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Trends in Bond Index Investing

Are investors getting more comfortable with this type of fund?

Christine Benz: Hi, I'm Christine Benz for Morningstar. Assets in passive equity strategies recently surpassed active equity fund assets in the U.S., but bond index fund adoption has lagged that of stock funds. Joining me to discuss the pace of bond index fund adoption is Rich Powers. He's head of ETF product management in Vanguard's portfolio review department.

Rich, thank you so much for being here.

Rich Powers: Great to be here.

Benz: Rich, let's discuss trends that you at Vanguard observe in the realm of bond indexing, or maybe bond indexing beyond Vanguard. Historically, it has lagged a little bit behind; maybe there's been a perception among some investors that this is a place where you want to use an active product. Let's talk about trends that you've seen, and it sounds like maybe you're seeing a little bit of a shift in terms of investors not using bond index products.

Powers: Well, the facts are that many investors have gotten comfortable with equity indexing, be it in a fund or an ETF. They are a little slower to come up the curve in terms of fixed-income indexing. There's a variety of reasons for that. If you just looked at mutual funds as an example, and we'll use our lineup as a good case study, we launched our first index equity ETF in 1976. Our first bond index mutual fund wasn't launched until 1987. Now, it was the first bond index mutual fund in the industry. But there's a 10-year head start for equities. Very similar experience on the ETF side of things. The first equity ETF was launched in 1993. The first fixed-income ETF was launched 10 years later. And so, there's this natural head start that I think investors gain in comfort with equity indexing as a concept more so than fixed-income indexing as a concept. But there are other considerations there as well.

Benz: So, more recently, it sounds like you have been seeing a fair amount of enthusiasm for bond indexing. Let's talk about what the data show and why you think that is.

Powers: Yeah. If you look at industry ETF AUM as a proxy for this, about 18% to 19% of all industry AUM is in fixed-income index ETFs. In contrast, the cash flows over the last couple of years would be more like 30% to 40% of the cash flows are going to fixed-income ETFs. And so, investors, by and large, are adopting in a greater degree than what they currently hold today suggesting they're getting comfort with fixed-income ETFs as a vehicle for them to achieve whatever objectives they are trying to deliver to their clients.

Benz: So, I think there's a lot to like about sort of a core total bond market index ETF as sort of a diversifier for an equity portfolio. But let's talk about what we hear from some active managers of bond funds, which is that, "Well, the index product really isn't representative of what we are doing." So, let's talk about some of the emphases in the bond index versus what we see in, say, the core intermediate-term bond products.

Powers: I mean, there's a couple key differences that you see in the active manager side of things relative to, say, a Barclays Bloomberg Aggregate, which our BND product tracks. First, an obvious one would be active funds tend to have a greater tilt towards corporate bonds than that broad market index offers. Secondly, the active manager will usually move duration depending upon their view of where rates are headed relative to that proxy benchmark. And then, thirdly, would be their active managers usually will dabble in non-investment-grade bonds. So, it will be high yield or non-U.S. fixed income, while the BND or the Barclays Bloomberg Index will focus exclusively on U.S. dollar investment-grade bonds.

Benz: So, the net effect of that would be that in some big equity market shock, the total bond market index, because it has very high credit quality overall, might tend to be pretty good ballast, but then in other environments, it might not perform as well because yield isn't as high.

Powers: Right. In an environment where yield spreads are tightening for credit and the active manager is overweight that, that's certainly a tailwind to the active strategy relative to a broad market fund like a broad market index like our BND tracks, given that about a third of that is in corporates and the active fund is probably going to have much greater exposure.

Benz: So, I think investors when they look at bonds today, whether a total bond market index fund or, even, say, an active intermediate-term fund or a short-term funds, certainly, yields are really low. And so, I talk to a lot of investors who might say, "Why do I need bonds at all in my portfolio when I can pick up a cash yield that's competitive and get away from all that interest-rate risk?" What do you say to that?

Powers: Sure. I think you have to remember why fixed income or bond portfolios are held in a diversified portfolio. And it's really to be a ballast or the shock absorber during very volatile market environments on the equity side of things. Likewise, if the investor is considering "I'll use a cash option instead," I think that investor needs to be cognizant of when is the right time to move to cash and when will be the next right time to move back into fixed income. As we know, through all the different academic studies that have been undertaken, the ability to call future market environments, to call interest rates, is very challenging for professional investors, let alone a retail investor or an advisor. And so, the strategic asset allocation is the key here, and if fixed income is meant to be part of that portfolio, keeping that relatively static over time is probably the right answer.

Benz: Okay. Rich, great to get your perspective. Thank you so much for being here.

Powers: Thanks, Christine.

Powers: Thanks for watching. I'm Christine Benz for Morningstar.