A Top-Rated ETF for Aggregate Bond Market Exposure

Of the 750-plus fixed-income exchange-traded funds on the menu, iShares Core U.S. Aggregate Bond ETF AGG is the largest. It is also one of the oldest fixed-income ETFs, having launched in September 2003. Long the barometer for U.S. investment-grade bonds, AGG's benchmark--the Bloomberg Barclays U.S. Aggregate Bond Index--has changed drastically in the years since the financial crisis. Prior to 2008, Treasury bonds made up approximately 20% of the index. Following a surge in government bond issuance, that number currently now sits at 40%.

Nonetheless, AGG is a great, core investment-grade bond strategy. It sports a conservative portfolio and one of the lowest expense ratios in the intermediate core bond Morningstar Category, earning a Morningstar Analyst Rating of Silver.

The Aggregate Bond Index includes investment-grade U.S.-dollar-denominated bonds with at least one year until maturity. The index is weighted by market value, tilting the portfolio toward the largest, most liquid issues, which are easy to obtain and cheap to trade. This approach also harnesses the market's collective wisdom about the relative value of each security. That said, bond issuing activity influences the composition of this portfolio.

The U.S. government is the largest debt issuer in the United States, so the portfolio maintains a larger position in Treasuries than the intermediate core bond category average. It has almost 65% of its assets in Treasuries and agency mortgaged-backed securities, which carry AAA ratings, while the corresponding figure for the category average is only about 40%. While this might limit the fund's return potential, its lower credit risk should offer better downside protection.

This is a conservative portfolio with minimal credit risk, which can make it a low hurdle for active managers. That does not make this an unattractive proposition, as risk and return are highly correlated in the fixed-income market. More than 70% of the assets in this portfolio carry a AAA rating, making it one of the more conservative options in the category. After controlling for risk, this portfolio is tougher to beat. Like most investment-grated portfolios, interest-rate risk is the biggest driver of returns here. Its average effective duration is about 5.5 years, as of this writing, while the category average is about 4.75 years.

The performance of the strategy during the trailing 10 years through November 2019 has been solid but not spectacular. Its returns have lagged its category average by approximately 6 basis points, ranking in the middle third of the category.

Fundamental View This strategy provides cheap exposure to the aggregate U.S. investment-grade debt market. Market-value weighting tilts the portfolio toward the highest credit quality issues, making it a solid choice. It probably won't top the category's return rankings, as it tends to take less credit risk than most peers. However, it should hold up better than peers when credit spreads widen, which tends to coincide with downturns in the economy and stock market.

Although broad, market-value-weighted bond funds like this one have been easier for active managers to beat than their U.S. equity counterparts, that doesn't mean the market is necessarily riddled with mispricing for managers to exploit. If anything, there is probably less room to find an informational edge in the investment-grade bond market than in the stock market because there is less uncertainty about bonds' future cash flows. Bonds that offer market-beating returns tend to come with greater risk.

This is a conservative portfolio, reflecting the size and quality of the U.S. investment-grade bond market. The amount of debt issued by the U.S. Treasury Department grew sharply since 2008, and the portfolio maintains a larger percentage of its assets in Treasury bonds compared with the category average as a result. Approximately 40% of the portfolio's assets are parked in Treasury bonds, while the category average is only 20%. The bulk of the fund's remaining balance is composed of agency MBS and corporate debt, which represent about 27% and 24% of the portfolio's assets, respectively. While this limits the fund's potential for returns, it also cuts potential losses. For example, the fund's index held up better than the category average during the financial crisis from October 2007 through March 2009. However, the fund's returns tend to look less compelling during credit rallies, when lower-rated bonds tend to outperform.

While the strategy takes less credit risk than most of its category peers, it does take on slightly more interest-rate risk. As of this writing, the fund's average effective duration was 5.5 years while the category average was 4.75 years. This may drag on the fund's category relative performance during periods of rising interest rates, but it should help when rates are falling. For example, it outperformed the category average by approximately 25 basis points during the period of July through August 2019, when the Fed cut the federal-funds rate 25 basis points.

Portfolio Construction This portfolio replicates the composition of the U.S.-dollar-denominated investment-grade bond market, effectively harnessing the market's collective wisdom about the relative value of each bond. This is a sound approach because it promotes low turnover and is cost-effective, and because the market does a decent job pricing these bonds.

The strategy employs representative sampling to track the performance of the Aggregate Index, which includes investment-grade U.S.-dollar-denominated bonds with at least one year until maturity. Qualifying bonds must have at least $300 million in outstanding face value. The index weights its holdings by market value and is rebalanced monthly. This yields a conservative portfolio, which limits its return potential, but also cuts downside risk.

Fees The strategy has an expense ratio of 0.05%, ranking in the category's top decile. The average expense ratio and median expense ratio of all funds in the category was 0.62% and 0.57%, respectively. During the trailing 10 years to November 2019, the fund lagged its benchmark by 10 basis points annually, likely attributable to sampling error.

Alternatives Silver-rated SPDR Portfolio Aggregate Bond ETF SPAB (0.04% expense ratio) and Silver-rated Schwab U.S. Aggregate Bond ETF SCHZ (0.04% expense ratio) both track the same index and have produced slightly tighter tracking results.

Silver-rated Vanguard Total Bond Market ETF BND (expense ratio 0.035%) is also a close alternative, tracking the Bloomberg Barclays U.S. Aggregate Float-Adjusted Index. This is similar to the Aggregate Index but it weights its MBS holdings based on the value available for public trading. So its portfolio looks very similar to AGG's.

Investors comfortable taking a little more risk might consider Silver-rated iShares Core Total USD Bond Market IUSB (expense ratio 0.06%), which includes U.S.-dollar-denominated, fixed-rate, taxable bonds across the entire credit spectrum with at least one year until maturity. High-yield bonds account for a small portion of this market-value-weighted portfolio, which should give IUSB a slight return edge over AGG. However, AAA-rated securities still represent the bulk of the portfolio.

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