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October 13, 2012

The Good and Bad About Bond Index

By Charles Rotblut

Though I believe in combining passive and active investing strategies, it is important to realize that not all indexes are the same. This is particularly the case when it comes to bond indexes. Bond indexes are harder for a manager to replicate than stock indexes because of multiple bond issues and liquidity constraints.
Most companies issue a single class of common stock. Even when there are two classes, stock indexes only hold one of the two classes. Berkshire Hathaway provides an example. The S&P 500 index holds class B shares (BRK.B), not the significantly more costly class A shares (BRK.A).
Conversely, many companies have multiple bond issues. A bond maturing in three years will have different characteristics than a bond maturing in seven years, even if both are issued by the same company. Thus, replicating a bond index is not as simple as merely adding General Electric (GE) bonds. The same issue has to be held in order to replicate the index.
Furthermore, because there can be several bond issues, liquidity can be a problem. A manager trying to track a specific bond index may not be able to buy a large enough position in a given issue to precisely track the performance of a bond index. This is particularly the case for a large portfolio or a large fund.
This does not mean bond indexes are bad, however. I personally hold the Vanguard Total Bond Market Index fund (VBMFX) in my 403(b) retirement account. Rather, it simply means that bond indexes are more difficult to replicate. Since they are more difficult to replicate, they are not as useful of a comparison tool to judge a bond manager’s performance by.
The S&P 500 serves as a useful comparison for measuring a large-cap stock manager’s performance because funds can easily replicate its composition. Since bond indexes are tougher to replicate, comparing a bond manager’s performance to them is often not an apples-to-apples comparison. A bond manager’s portfolio may have different maturities, duration (a measure of sensitivity to changes in interest rates), yield or credit quality. All of these can impact comparative performance.
This is not to say that you should avoid comparing an active bond manager’s performance against that of an index, but rather that you should consider using more than one measure. Add to the mix comparable bond funds (e.g., U.S. long-term general bond funds) to provide a broader base of benchmarks. Plus, consider whether there are reasons beyond the manager’s talent (or lack thereof) playing a role.
The Week Ahead
Approximately 80 members of the S&P 500 will report earnings next week. Included in this group will be Dow components Coca-Cola (KO), Intel (INTC), International Business Machine (IBM), Johnson & Johnson (JNJ) and UnitedHealth Group (UNH) on Tuesday; American Express Company (AXP) and Bank of America (BAC) on Wednesday; Microsoft (MSFT), The Travelers Companies (TRV), Verizon (VZ) on Thursday; and General Electric (GE) and McDonald’s (MCD) on Friday.
On the economic front, September retail sales, the October Empire State Manufacturing Survey and August business inventories will be announced on Monday. Tuesday will feature the September Consumer Price Index (CPI), September industrial production and capacity utilization, and the October National Association of Home Builders housing index. September housing starts and building permits will be announced on Wednesday. Thursday will feature the October Philadelphia Federal Reserve survey and September leading indicators. September existing home sales will be announced on Friday.
The Treasury Department will auction $7 billion of 30-year inflation-protected securities (TIPS) on Thursday.
October stock options expire on Friday.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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