Most investors are inherently familiar with index investing in the equity markets, but less so with indexing in fixed income. As a result of this lack of understanding, a growing number of publications—produced mainly by active managers—are questioning the validity of indexing in fixed income. Many of the generalizations stated in these pieces are born out of incomplete knowledge of how indexed fixed income exposures are actually managed and used in practice.
A popular expression today is that “bonds are different”, which infers that indexing cannot or should not work in fixed income in the way that it does in equities. BlackRock agrees that bonds are different, but also argue that the very nature of the bond market is exactly why indexing is so valuable.
Indexing effectively transforms a highly fragmented and discontinuously liquid bond market by aggregating it, standardizing it, and making it more transparent. This standardization and transparency create cost effective, actionable exposures that make fixed income portfolio construction and management far more efficient.
In Index Your Bonds, BlackRock addresses seven common myths about fixed income indexing:
Myth #1: Fixed income indexes assign the largest weights to the most indebted issuers, which are the riskiest.
Myth #2: Index funds are forced buyers and sellers of securities when they rebalance at each month end, and they cannot participate in the new issue markets.
Myth #3: Fixed income index funds are forced to incur transaction costs by trading excessively to match their reference benchmarks. High turnover costs lead to underperformance relative to actively managed funds, which have more “flexibility”.
Myth #4: Fixed income indexes by definition cannot be flexible or nimble, resulting in lost tactical opportunities and underperformance in adverse market conditions.
Myth #5: Fixed income is too broad of an asset class, with too many bonds to index effectively.
Myth #6: Index investors and non-economic investors make suboptimal investment decisions and create numerous market distortions.
Myth #7: Active fixed income managers consistently beat their benchmarks and passive strategies over time and do so by exploiting inefficiencies in the bond market.
In essence, this paper illustrates that many of the myths surrounding fixed income indexing strategies are simply not true. Often, performance differences can be due to benchmark selection, erroneous benchmark comparisons within sectors and out of benchmark structural tilts. In reality, many index-based investments like ETFs have generated returns that are very competitive with active funds in their category.
The broadening range of fixed income indexes, index funds and ETFs affords investors an increasing degree of precision. Portfolio composition can be adjusted rapidly and efficiently to seek opportunities without having to trade multiple bonds. Index funds and ETFs can be used to cost-effectively scale portfolios, enabling portfolio managers to focus on higher conviction trades.
For all of these reasons, BlackRock believes that not only does fixed income indexing works, but that it will become an indispensable component for all fixed income portfolios.
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