Review & Outlook

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Vanguard’s Case for Active Management: Problems with Bond Index Funds

As I’ve written previously on our blog, one of the firms that makes a strong case for the value of actively managed investment portfolios is Vanguard.  If this sounds paradoxical, it’s only because there’s a lot of public misunderstanding about what the debate over “active vs. passive” investing is really about, and because many people don’t know that Vanguard runs highly successful actively managed funds.

Therefore, to borrow a motif from biblical scholarship, there’s something of a “Bogleheads of faith” vs. “Vanguard of history” phenomenon in the investing world today: according to the faith-based religion of passive index investing, there’s a battle between good (passive) and evil (active), and the good are mathematically predestined to triumph due to low fees, broad market indexes, and mean-reversion over time.  According to the actual history of fund managers like Vanguard, however, actively managed portfolios can and do reliably outperform their benchmark indexes, and more importantly, the very task of index creation and management is fraught with discretionary, actively managed judgments to such a degree that pure “passive” investing is a myth.  (See also here.)

Vanguard again has demonstrated its commitment to active investment management with a recent announcement that this year it will be launching an actively managed bond mutual fund.  Here is the report from Barron’s.

The goal of the Vanguard Core Bond Fund will be to “outperform the broad investment-grade U.S. fixed income market” with a mix of mostly high-rated Treasury, mortgage-backed and corporate bonds — the same broad categories that comprise the Barclays U.S. Aggregate Bond Index.

The fund will be co-managed by a trio of Vanguard fixed-income veterans: Gregory S. Nassour, Brian Quigley, and Gemma Wright-Casparius, senior portfolio managers in Vanguard’s Fixed Income Group.

The new fund won’t be a niche or specialized sector fund; it’s designed to be a core holding in an investor’s fixed-income portfolio.   Note too that the fund’s goal is to outperform the investment-grade U.S. bond market.  According to the Bogleheads of Faith, of course, trying to outperform a broad market index is foolish, so why is Vanguard setting about to do it?

The rationale arises from deficiencies with the Barclays U.S. Aggregate Index, which is the most commonly followed index of U.S. investment-grade fixed-income securities.  (If you’ve got an index-tracking US investment-grade bond fund in your portfolio, then your fund is probably tracking the Barclays index.  This index used to be provided by Lehman Brothers before that bank’s demise.)  The Barclays Agg is deficient as an investment tool because, like other market-capitalization weighted bond indices, it privileges the most indebted bond issuers.  That is, the more a company (or the US government) borrows by selling investment-grade bonds, the greater weight those bonds must be given in the index, because the more of such bonds there will be in the market.  For investors whose money is tracking the index, it forces them to buy blindly whichever bond issuers are borrowing the most.  If this sounds like a questionable investment strategy, it is, which is why Vanguard felt the need to launch an actively managed fund whose managers can select which bonds to buy.

In the aftermath of the financial crisis of 2008-2009, the Barclays index has become heavily distorted by government borrowing.  Here are the bond sector weightings of the iShares ETF (AGG) that tracks the Barclays Agg Index, as compiled by



As you can see, there’s a huge weighting toward US treasuries and mortgage-backed securities, over 60% of the Index.  This weighting has had the effect of lowering the Index’s yield while increasing its sensitivity to a rise in interest rates.  Few investors would have reason to compose such an allocation deliberately, but index-tracking bond portfolios have been forced to do so.  The Barclays Agg isn’t a bad product and there still can be reason to own a fund that tracks it.  But it’s welcome news that Vanguard will be offering a new fund solution to investors who don’t have sufficient assets to own a diversified portfolio of individual investment-grade bonds directly.