This article is part of Morningstar's Guide to Passive Investing special report.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. In the past, many investors preferred actively managed bond funds, but that seems to be changing. Joining me to provide an overview of the passive bond funds landscape is Alex Bryan. He is director of passive research strategies for Morningstar in North America.
Alex, thank you so much for being here.
Alex Bryan: Thank you for having me.
Benz: Alex, let's talk about when you look at where flows have gone to passive funds, what types of passive bond funds have investors been buying?
Bryan: For the most part, money has been going toward broad market-cap-weighted fixed-income strategies, like funds that track the Bloomberg Barclays Aggregate Bond Index. You also have a lot of funds that track specific sectors, sleeves of the credit in duration spectrum that are market-cap-weighted that have also attracted a lot of assets. But for the most part, they are pretty plain-vanilla strategies.
Benz: The total bond market seems to be where a lot of investors are going?
Benz: One thing with total bond market index funds though is that you do get pretty heavy government bond exposure, right?
Bryan: That's right. If we take funds that track the Bloomberg Barclays Aggregate Bond Index, for example, this is an index that provides broad exposure to the investment-grade market in the U.S. and then weights its holdings based on market capitalization. Now, what that does is it tends to skew the portfolio toward the most heavy debt issuers, which in the case of the U.S. investment-grade market is the U.S. Treasury. Most index funds do offer higher exposure to U.S. Treasuries than their actively managed counterparts. Now, that means that they are taking less credit risk than their actively managed counterparts. They tend to hold up a little bit better when credit spreads widen and that often happens during tough economic environments. But they also offer lower yields, because they are taking less risk, so they may not keep pace when credit pays off over the long term.
Benz: In terms of something that is going to maybe counterbalance my equity portfolio's exposures, it seems like something that's heavy on government bonds, at least historically, has fared pretty well in a tough equity market environment?
Bryan: That's right. If you are looking for something that's a bit more defensive to help balance your portfolio out when stocks may not be doing quite as well, something that's a little bit heavier in Treasuries is actually not such a bad thing because it does provide a little bit better diversification than riskier bonds might.
Benz: Let's talk about some of the favorite passively managed sort of core funds and ETFs that you and the team like. Let's talk about the ones that you guys recommend.
Bryan: If you want to stay within the investment-grade segment of the U.S. bond market, something like the Vanguard Total Bond Market ETF is a great option for you. It basically provides broad exposure to the U.S. investment-grade bond segment and then weights its holdings based on market capitalization. It does have heavier exposure to Treasuries as we talked about, than most of its active peers and a little bit less exposure to securitized debt. But overall, we really like that the fund provides broad diversification, it's defensive and it only charges 5 basis points. That's definitely something to like about this fund.
Now, if you are comfortable taking a little bit more credit risk, you might consider the iShares Core Total USD Bond Market ETF, ticker IUSB. Now, what this fund does is it owns both investment-grade and noninvestment-grade bonds, and it weights its holdings based on market capitalization. It parks about 8% to 10% of its assets in high-yield bonds. It still has a pretty conservative portfolio overall. In fact, 60% of the portfolio is parked in AAA-rated securities. But because it does include some high-yield bonds, it gives you a slightly higher yield which may reward you over the long term. We like this fund because it's broadly diversified and it charges a very low 6 basis points expense ratio.
Benz: Let's talk about categories that should not be indexed in the fixed-income universe. Any places where you say, here's a spot where investors should really go with an actively managed product?
Bryan: High-yield bond and less liquid areas of the bond market might be a good place to prefer active over passive. High-yield bond is a great example, because this is an area where there is a lot of liquidity risk, and whenever you index an area of the market, you are mechanically trading in and out of securities and that can move market prices away from you. That could be problematic. Then also in less liquid areas of the market there might be more asymmetric information where there's a greater payoff to doing fundamental credit research. I think, high-yield bond is a great example of that where, do you want management of both the credit and liquidity risk.
Now, fees still matter here. They matter no matter where you are even in the less efficient, less liquid areas of the market. It's important to stick to low-cost active if you are going to invest in these areas of the market. In the high-yield bond segment, for example, we really like the Vanguard High-Yield Corporate Fund which is very inexpensive; in fact, it's cheaper than any of the index options in the category. It also has a little bit more of a conservative bent to it than most index funds in the category, kind of shunning the lower-quality CCC securities and tilting more toward the BBs.
Benz: Alex, always great to get your insights. Thank you so much for being here.
Bryan: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.