Case for indexing is weaker for bonds

There is no need to rhapsodise further on the symbolism of this week's news that Pimco's Total Return fund, for many years the world's largest mutual fund and the flagship for Bill Gross, had seen its assets fall below those of a Vanguard bond index fund.

Mr Gross may well prove to be the last exemplar of a manager's fame being used to sell money management to the mass market. But public disenchantment with big active fund managers set in a while ago. What is more intriguing is the ascendancy of indexing in fixed income.

I am enthusiastic about equity index funds. But the arguments in favour of indexing are weaker when it comes to bond funds. The difference in costs is less, their performance relative to indices is far more erratic, and the indices themselves are built on questionable grounds, guiding investors towards whichever borrowers have issued the most debt. By making itself riskier and more indebted, an issuer at the same time increases its weight in indices.

For true "buy and hold" investors, just buying a bond and adding a few more over the years might be a valid alternative. The choice of government bonds is far narrower than the choice of stocks.

And then, particularly for exchange traded funds that venture into the more esoteric areas of fixed income, there is a potential systemic risk from liquidity mismatches; life could get difficult if a lot of ETF shareholders want their money in a hurry.

These issues explain why indexing has made less headway in fixed income. In the US, according to Morningstar, passive open-ended and exchange traded funds account for only 19.9 per cent of the $3.6tn in bonds under management. Yet a move to bond indexing is under way.

The greatest issue with bond indexing, compared with equity indexing, is its erratic performance compared with active managers. So much depends on active managers' call on rates. When they call central banks correctly, tracking funds lose badly.

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However, in the longer term active bond funds still get pummelled by the index. SPIVA's figures only go back 10 years but they show 95.4 per cent of long bond managers losing to their index over this period, along with 93 per cent of high-yield managers.

The events of the past two years demonstrate that it is difficult to get the interest rate call right. And yet calling interest rates is expensive. You need to hire high-powered and well-connected economists, and do a lot of research, which is not ultimately well-rewarded.

But indexed bond management's flaws remain. That creates a natural opening for "smart beta" - quantitative strategies that follow a strict discipline, without manager discretion, but without tracking an index weighted according to debt outstanding.

Such strategies are the flavour of the month in equities, and also make sense for bonds. Shane Shepherd of Research Affiliates, best known as a pioneer of "fundamental indexing" in equities, explains that bond funds can be weighted according to their debt-servicing capacity, rather than their total issuance.

For corporate bonds, this means looking at cash flow (on a five-year average basis) and long-term assets to estimate the collateral that is available for bond holders. For sovereigns, funds can be weighted by gross domestic product, or population. This tends to give a portfolio a "quality" bias, favouring companies and countries with lots of assets and with strong debt coverage. It also leans against the strategy of "reaching for yield" - taking higher risks in return for eking out slightly more of an income.

Does this work? According to back tests to 1997, such strategies have managed to add 80 basis points per year to returns in developed market bonds, 40bp in investment-grade bonds and an impressive 200bp in high-yield.

With bonds, there are drawbacks to both active management and indexing. In the long term, the chances are good that the largest bond fund will be neither a tracker nor a fund run by a bond maestro and more like a quantitative "smart beta" fund.

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