The Efficacy Of Bonds
This brings us to the second core belief of most investors: the efficacy of bonds for diversification and risk reduction. One little-known fact is that the classic 60/40 balanced portfolio has roughly a 98 percent correlation with stocks. Figure 7 shows the monthly returns for a 60 percent S&P 500/40 percent BarCap Aggregate portfolio against the returns for the S&P 500 over the past 40 years. The 60/40 portfolio gave us 38 percent less risk than the S&P 500. A 38 percent allocation to T-bills would have served as well for risk reduction.
However, the 60/40 portfolio gave us an intercept (at zero stock market return) of 2.0 percent per annum, 1.4 percent better than a 38 percent T-bill allocation would have delivered. These data clearly show that—at least over the past 40 years—the BarCap Aggregate has been a far better way to reduce portfolio risk than cash. The slope of the yield curve is usually steep enough that the bonds do reward us well beyond their theoretical position on the CAPM market line.
Diversification is another matter. Let’s assume that the goal of diversification is to reduce our risk by taking on new, uncorrelated risks in order to seek equitylike returns at bondlike risk—our industry’s holy grail—rather than merely to invest some of our money in low-volatility markets.8 Most would suggest that other risky assets should serve this purpose—if they offer an uncorrelated risk premium (e.g., if that risk premium is related to risk, not to beta). Conventional mainstream bonds do not serve us well in this regard, though many alternative bond categories do offer something closer to this definition of true diversification.
Consider Figure 8, which is a classic risk/reward chart spanning the 10 years from March 1999 through February 2009. Thankfully, nothing on this graph offers equitylike return, other than stocks themselves: Everything else has performed far better. Much as we just determined, our 60/40 investor did barely better than the linear capital market line suggests (although stocks dragged our 60/40 investor perilously near the zero-return line for the 10 years ended February 2009). But, the conventional bonds (represented by the BarCap Aggregate) bring our risk down more because of their own low volatility rather than because of an uncorrelated risk premium.
Over this decade, we had an array of asset classes at our disposal, many of which produced respectable returns; one even edged into double digits. A naive portfolio holding all of these asset classes equally would have delivered 5 percentage points more return, at a lower volatility, than our 60/40 investor. We can achieve true diversification by holding multiple risky markets with uncorrelated risk premia, and so lower our risk without simply relying on low-volatility markets. Achieving true diversification requires broadening our horizons well beyond conventional allocations to stocks resembling the S&P 500 and bonds resembling the BarCap Aggregate. Mainstream bonds alone don’t get us there.
The Problem With Bond Indexes
Let’s finally examine the mean-variance efficiency of the bond indexes. In 2001, Argentina’s debt swelled beyond 20 percent of the major Emerging Markets Bond indexes. Mohamed El-Erian, then manager of Pimco’s Emerging Markets Bond product suite, was repeatedly asked by other investors and observers, “How can you have no holdings in Argentina when it’s over 20 percent of your benchmark index?” He famously replied, “because it’s over 20 percent of the index and yet its fundamentals are rapidly deteriorating.” Why buy bonds from issuers that have already borrowed more than they can hope to repay? And yet, the more debt that a company or country issues, the more that a market-value-weighted bond index will “own” of that company’s debt. El-Erian’s succinct observation is kindred to the oft-cited cliché that banks will only lend you money if you don’t need it.9 The bond investor’s favorite investment ought to be with a borrower who can readily afford to repay the debt.
The thoughtful observer will notice that, in this regard, bond indexes are no different from any other indexes. Consider when Cisco was nearly 4 percent of the S&P 500 (with barely 20,000 employees worldwide) and Nortel exceeded 30 percent of the Canadian market—both at the peak of the Tech bubble in 2000; consider when GM and Ford together comprised 12 percent of the U.S. High-Yield Bond Index in 2006, and when Yukos was 17 percent of the Russian stock market in 2003. In each case, that hefty weight reflected (among other things) the fact that the price was—with the blessings of hindsight—far too high, masking troubles that became evident quickly enough.
Let’s start with the simple precept that we want to own more of any assets that we expect will deliver the highest returns. If that’s so, then if we own twice as much of an asset that has recently doubled in price—as we do in our cap-weighted index portfolios—the asset logically must be more attractive after doubling than it was at half the price. Such is the “Alice in Wonderland” logic of conventional cap-weighted indexes.
One difference between stock and bond investors is that bond investors viscerally understand that if a creditor issues more debt, we don’t necessarily want to own more of that issuer’s debt. By contrast, many equity market investors are comfortable with the idea that our allocation to a stock doubles if the share price doubles; most bond investors are not. This is one of the reasons that bond index funds have not caught on nearly to the extent that stock index funds have.
Our research on the Fundamental Index® concept, as applied to bonds, underscores the widely held view in the bond community that we should not choose to own more of any security just because there’s more of it available to us.10 Figure 9 plots four different Fundamental Index portfolios (weighted on sales, profits, assets and dividends) in investment-grade bonds (green), high-yield bonds (blue) and emerging markets sovereign debt (yellow).11 Most of these have lower volatility and higher return than the cap-weighted benchmark (marked with a red dot). And, the composite of the four indexes (marked with a grey dot) has better risk or reward characteristics than the average of the single-metric noncap indexes. Unsurprisingly, the opportunity to add value is greatest in emerging markets, substantial in high yield and less impressive in investment-grade debt, where the gap between fair value and price is likely to be small.
Investors clearly want index exposure to bond markets (bond index funds and ETFs), but are wary of the fact that conventional bond indexes will load up on the most aggressive borrowers’ bonds. Index products can be constructed in ways that make the portfolio less vulnerable to the indexers’ Achilles’ heel: overrelying on the overvalued and vulnerable assets. The Fundamental Index concept is an elegant and simple way to do so. Equally weighted portfolios, minimum variance portfolios, maximum diversification portfolios and other structured products may do as well, or even perhaps better. But, the key is to get the price out of the weighting formula.