Larry Swedroe: Active Fails In Fixed Income

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Random Walker
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Larry Swedroe: Active Fails In Fixed Income

Post by Random Walker » Fri Mar 02, 2018 10:03 am

http://www.etf.com/sections/index-inves ... nopaging=1

Active management is a loser’s game in the bond world as well; no surprise to Bogleheads. Very worthwhile read even if you think you know it already. Reviews both older and most recent data. Strong reference to Bogle and the tremendous importance of costs. Active managers who beat an index probably do it with additional credit risk. Very interesting note near the end that active funds with additional credit risk have the sign of their correlation to equities turn positive at just the wrong time!

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by JBTX » Fri Mar 02, 2018 10:57 am

Good to see research back up what seems like common sense. It is hard to figure how active managers can beat an index with a 2-3% interest rate and 1.0% management fees. The assertion that bonds were different never made much sense to me. I think in the case over the years Bill Gross was able to marginally outperform indexes by changing the portfolio around making bets but the outperformance wasn’t dramatic.

http://quotes.morningstar.com/chart/fun ... ture=en_US

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by statman » Fri Mar 02, 2018 4:27 pm

Hmmm. Vanguard's Tax-Exempt bond funds are actively managed and low cost. Do we really want to index (presumably by random sampling from the very large universe) muni bond investments? Reminds me of a doctor friend who bought individual munis, including some linked to a hospital in New Orleans. When there for a convention, he asked a cabbie to take him past the place. "Oh, you mean the New Orleans knife and gun hospital?" He lost his money. I would rather Vanguard perform due diligence for me.

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by alec » Fri Mar 02, 2018 4:49 pm

statman wrote:
Fri Mar 02, 2018 4:27 pm
Hmmm. Vanguard's Tax-Exempt bond funds are actively managed and low cost. Do we really want to index (presumably by random sampling from the very large universe) muni bond investments? Reminds me of a doctor friend who bought individual munis, including some linked to a hospital in New Orleans. When there for a convention, he asked a cabbie to take him past the place. "Oh, you mean the New Orleans knife and gun hospital?" He lost his money. I would rather Vanguard perform due diligence for me.
From the article:
Is Past Performance Predictive?
Being a loser’s game does not mean there aren’t some winners, offering the hope that somehow we can identify the few winners ahead of time. Unfortunately, the evidence suggests that believing this is possible in a reliable way would be the triumph of hope over experience.

For example, in his 1994 book “Bogle on Mutual Funds,” John Bogle studied the performance of bond funds and concluded that “although past absolute returns of bond funds are a flawed predictor of future returns, there is a fairly easy way to predict future relative returns.”

He continues: “The superior funds could have been systemically identified based solely on their lower expense ratios.” Other studies on the subject, including those on municipal bond funds, all reach the same conclusions:

-Past performance cannot be used to predict future performance.

-Actively managed funds do not, on average, provide added value in terms of returns.

-The major cause of underperformance is expenses; there is a consistent one-for-one negative relationship between expense ratios and net returns.
Hence, low cost actively managed bond funds are fine.
"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by staythecourse » Fri Mar 02, 2018 4:54 pm

statman wrote:
Fri Mar 02, 2018 4:27 pm
Hmmm. Vanguard's Tax-Exempt bond funds are actively managed and low cost. Do we really want to index (presumably by random sampling from the very large universe) muni bond investments? Reminds me of a doctor friend who bought individual munis, including some linked to a hospital in New Orleans. When there for a convention, he asked a cabbie to take him past the place. "Oh, you mean the New Orleans knife and gun hospital?" He lost his money. I would rather Vanguard perform due diligence for me.
Interesting I would think that example of the doc is an example FOR active management. My assumption is that all the information is already known and incorporated in the price already so that the chance of repaying the debt would be reflected in its coupon rate. I would say the point is it doesn't matter WHO is picking what bonds as the price already reflects its default risk and term risk.

Good luck.

p.s. Agree with the above poster as even if there is role in active management the returns are so clustered that any management fee is likely to erase any advantages.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

stlutz
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Re: Larry Swedroe: Active Fails In Fixed Income

Post by stlutz » Fri Mar 02, 2018 9:11 pm

Wow-I think this is a pretty significant shift for Swedroe. In the past he has advocated for all sorts of active management in fixed income, such as:

--Using a variable maturity strategy where you must get 20 bps. of additional return for each year of maturity you extend out.
--Avoiding bonds with significant call risk.
--Only buying individual municipal bonds (with only high ratings and not from a list of 10 states with the biggest pension problems) as opposed to just settling for some ETF like VTEB or TFI.
--Taking credit risk where he believes it will be well-rewarded (i.e. the recent shift from regular bonds to a relatively-high-cost-peer-to-peer lending fund).

Obviously everybody engages in some type of "active management" in assembling a portfolio. It's just that Swedore has generally been pretty active on the fixed income side. What made him interesting before the P2P lending thing came along was that he generally advocated for active management in the opposite direction of what most fund managers do--i.e. take less risk than the market as a whole instead of more.

I have noted in the past that one can definitely backtest for bond strategies that work well--the variable maturity strategy is one of those. However, backtests of backtesting provide a less clear record. Up until the late 90s, backtests showed the short maturity bonds were better than long maturity bonds. Of course what followed was two decades where the opposite was the way to go. This record has made me wonder whether just going with TBM is the best plan.

Disclosure: I invest in actively-managed bond funds, index bond funds and ETFs, and have some actively managed individual bond holdings (selected using Swedore's variable maturity and low credit/call risk approaches).

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Random Walker » Fri Mar 02, 2018 9:39 pm

I think VG’s muni bond fund is only technically an active fund. It’s basically an index fund for all intents and purposes I think.

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Random Walker » Fri Mar 02, 2018 9:55 pm

I could be wrong but I seriously doubt that this represents a significant shift for Larry. He has always viewed the bond side of the portfolio the safe side. So he has always recommended highest quality and short to intermediate duration. I do think he does sometimes think it is more opportune to extend maturity a small amount compared to other times. I don’t have much understanding of the shifting maturity strategy. I expect he would agree there are no free lunches in the bond market. In fact I bet he would say that if we perceive one, then we just haven’t identified the risk yet. I think he likes to avoid some bond mutual funds because they necessarily include some bonds of lower quality, longer duration, high tax states, GNMAs, etc. But those issues don’t mean he doesn’t believe the market is efficient. I think his recommendations stem mainly from the belief that risk is better taken on equity side.
With regard to alternative lending, I think this is much more viewed as an alternative asset class rather than a category of bonds. Of course one might create the position from either stocks or bonds, but they are clearly different beasts from much more liquid higher quality anchors to a portfolio.
I’m a bit iffy on bonds, so if I’ve made any mistakes describing his writings, the blame is all on me. :-)

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by stlutz » Fri Mar 02, 2018 11:32 pm

Regardless of what Swedroe is personally doing, his article does raise good questions. As noted, my fixed income portfolio is more complex than, say, Taylor would advise. I have specific reasons for all of my choices and I can point to specific decisions I've made that I think have provided superior returns, such as moving in and out of TIPS based whether I thought the inflation breakeven was credible, periodically taking advantage of brokered CDs when the yield premium over treasuries is significant, and the like.

So, I can look and pat myself on the back for some "good" decisions. However, have my decisions collectively meant that I've done better than I would have had I just stuck with Total Bond? A couple of good tactical moves may not make up for poor strategic decisions. I quite honestly haven't run the numbers--in part because it's complex to do so and in part because I think I know what the answer is. Perhaps if I find some time in the next couple of days I'll try to calculate this.

And it's probably worthwhile to do the same with Swedroe's various recommendations over time. How have they collectively done in one's portfolio vs. Total Bond? Would be interesting to figure this out. But, of course, in order to do that we do have to ascertain exactly what his recommendations are and have been over the time period being measured.
Last edited by stlutz on Fri Mar 02, 2018 11:56 pm, edited 2 times in total.

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by AlohaJoe » Fri Mar 02, 2018 11:36 pm

stlutz wrote:
Fri Mar 02, 2018 11:32 pm
And it's probably worthwhile to do the same with Swedroe's various recommendations over time. How have they collectively done in one's portfolio vs. Total Bond? Would be interesting to figure this out. But, of course, in order to do that we do have to ascertain exactly what his recommendations are and have been over the time period being measured.
I'm always a bit surprised that the advisors who write these books and articles don't do more of this. They have dozens, or hundreds, of clients. Presumably they could find a few who are following these recommendations and show an anonymised case study of how it works out. Something like:

"Client A joined us and was initially risk averse so we put them in TBM. After 2 years of working with us, we convinced them to switch to X, then after 18 months we did Y, etc, etc."

If doctors can publish about patients I'm not sure why advisors can't do the same.

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Robert T » Sat Mar 03, 2018 10:44 am

.
A quote from the article:
The winning strategy for investors is the same for both stocks and bonds: Decide how much exposure you desire to common factors, and then implement the appropriate allocations using the lower-cost, passively managed mutual funds and ETFs that give you the most effective exposure (considering not only expense ratios but also fund construction rules and trading strategies) to those factors.
Agree!!

"Over the long haul, what matters is factor exposure and expense" - Bill Bernstein

The challenge with fund construction and trading strategies is there is often a lot of marketing noise around them. Fund construction rules and trading strategies tend to change factor exposure exposure rather than add alpha (re: Keim's earlier paper http://pillarcapital.com/acorn/themes/p ... _paper.pdf). Two useful metrics for me for 'purity' of factor exposure are highest R^2 and closest to zero alpha in the Fama-French factor models (preferably assessed over a long periods). Admittedly there is a bit more noise in the Fama-French 2 factor bond model (perhaps due to non-linearities) - but the two metrics still useful on a relative basis IMO. Again - longer time horizons better for assessments than shorter time periods.

The above approach simplifies dramatically the decision making process in assessing options to one question - can it help achieve my targeted factor loads/exposure at lower cost.

Works for me.

Robert
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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Sandtrap » Sat Mar 03, 2018 10:48 am

alec wrote:
Fri Mar 02, 2018 4:49 pm
statman wrote:
Fri Mar 02, 2018 4:27 pm
Hmmm. Vanguard's Tax-Exempt bond funds are actively managed and low cost. Do we really want to index (presumably by random sampling from the very large universe) muni bond investments? Reminds me of a doctor friend who bought individual munis, including some linked to a hospital in New Orleans. When there for a convention, he asked a cabbie to take him past the place. "Oh, you mean the New Orleans knife and gun hospital?" He lost his money. I would rather Vanguard perform due diligence for me.
From the article:
Is Past Performance Predictive?
Being a loser’s game does not mean there aren’t some winners, offering the hope that somehow we can identify the few winners ahead of time. Unfortunately, the evidence suggests that believing this is possible in a reliable way would be the triumph of hope over experience.

For example, in his 1994 book “Bogle on Mutual Funds,” John Bogle studied the performance of bond funds and concluded that “although past absolute returns of bond funds are a flawed predictor of future returns, there is a fairly easy way to predict future relative returns.”

He continues: “The superior funds could have been systemically identified based solely on their lower expense ratios.” Other studies on the subject, including those on municipal bond funds, all reach the same conclusions:

-Past performance cannot be used to predict future performance.

-Actively managed funds do not, on average, provide added value in terms of returns.

-The major cause of underperformance is expenses; there is a consistent one-for-one negative relationship between expense ratios and net returns.
Hence, low cost actively managed bond funds are fine.
Whew!
That was a close one. :shock:
Thanks for the analysis.. . and confirmation.
j :D

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by patrick013 » Sat Mar 03, 2018 1:33 pm

Sandtrap wrote:
Sat Mar 03, 2018 10:48 am
alec wrote:
Fri Mar 02, 2018 4:49 pm

From the article:
Is Past Performance Predictive?

-The major cause of underperformance is expenses; there is a consistent one-for-one negative relationship between expense ratios and net returns.
Hence, low cost actively managed bond funds are fine.
Whew!
That was a close one. :shock:
Thanks for the analysis.. . and confirmation.
j :D
So if we stay with investment grade bonds, adjust maturities according to the market,
enjoy the lack of expenses and index limitations, we may very well increase cap gains
and total returns. Easier for some than others but I think most investors could easily
adjust maturities (not duration) to take advantage in most markets using funds or upper
investment grade individual securities.
age in bonds, buy-and-hold, 10 year business cycle

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by cfs » Sat Mar 03, 2018 1:42 pm

Thank you Mister Dave for the link to the article.

Mister Swedroe is no longer participating in this forum for good reasons [our loss].

My signature applies, y gracias por leer ~cfs~
~ Member of the Active Retired Force since 2014 ~

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Theoretical » Sat Mar 03, 2018 2:04 pm

The Vanguard Tax-Exempt "active" funds are hard to really describe as active, as they have miniscule turnover, sometimes lower even than the Muni Index, and they have twice as many holdings.

At most, by their behavior, they do a bit of yield curve positioning, but are still closet index funds.

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by goodenyou » Sat Mar 03, 2018 2:51 pm

statman wrote:
Fri Mar 02, 2018 4:27 pm
Hmmm. Vanguard's Tax-Exempt bond funds are actively managed and low cost. Do we really want to index (presumably by random sampling from the very large universe) muni bond investments? Reminds me of a doctor friend who bought individual munis, including some linked to a hospital in New Orleans. When there for a convention, he asked a cabbie to take him past the place. "Oh, you mean the New Orleans knife and gun hospital?" He lost his money. I would rather Vanguard perform due diligence for me.
We call that “Dumb Doctor Mistakes “. I am a doctor and I have many colleagues that have made them. I could share many.
Last edited by goodenyou on Sat Mar 03, 2018 2:58 pm, edited 1 time in total.
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Re: Larry Swedroe: Active Fails In Fixed Income

Post by jebmke » Sat Mar 03, 2018 2:55 pm

Theoretical wrote:
Sat Mar 03, 2018 2:04 pm
The Vanguard Tax-Exempt "active" funds are hard to really describe as active, as they have miniscule turnover, sometimes lower even than the Muni Index, and they have twice as many holdings.

At most, by their behavior, they do a bit of yield curve positioning, but are still closet index funds.
Index funds are only a subset of passive. We were in a private SCV equity pool for 20 years that I would describe as passive. The turnover was extremely low and the stocks were all picked and held by the fund manager. He rarely sold anything. But it was not an index investment.
When you discover that you are riding a dead horse, the best strategy is to dismount.

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by ImUrHuckleberry » Sat Mar 03, 2018 3:04 pm

cfs wrote:
Sat Mar 03, 2018 1:42 pm
Thank you Mister Dave for the link to the article.

Mister Swedroe is no longer participating in this forum for good reasons [our loss].

My signature applies, y gracias por leer ~cfs~
Why is that?

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Sandtrap » Sat Mar 03, 2018 3:26 pm

ImUrHuckleberry wrote:
Sat Mar 03, 2018 3:04 pm
cfs wrote:
Sat Mar 03, 2018 1:42 pm
Thank you Mister Dave for the link to the article.

Mister Swedroe is no longer participating in this forum for good reasons [our loss].

My signature applies, y gracias por leer ~cfs~
Why is that?
viewtopic.php?t=217022
This is why.
j

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Robert T » Sat Mar 03, 2018 5:25 pm

.
For what its worth - here's my earlier take on a shifting maturity/duration approach ....
  • on shifting maturities/duration (as used by some of the DFA funds). IMO, Fama’s research results underlying this method are not as robust (good research, just weak results IMO) as some of his other research result (such as that in the Common Risk Factors in the Returns on Stocks and Bonds). For example from the article on Update of the Research Underlying Dimensional's Bond Strategies Fama concludes “The implication of regression slopes close to 1.0 in Table 1 is that the wanderings of forward-spot spreads on average show up one-for-one as wanderings in term premiums. This is the basis of Dimensional's variable maturity strategies, and it is the source of their value added over fixed maturity strategies.” Now if we look closely at Table 1, the explanatory power of the models is very low. i.e. the variation in forward spreads explain between 2% and 13% of the variation in term premiums (much weaker than the 95% explanatory power of the FF equity factors). As a result, I’m less inclined to shift between short and intermediate term (based on these results).
Robert
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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Robert T » Sat Mar 03, 2018 5:34 pm

.
--Using a variable maturity strategy
For what its worth - here's my earlier take on a shifting maturity/duration approach ....
  • on shifting maturities/duration (as used by some of the DFA funds). IMO, Fama’s research results underlying this method are not as robust (good research, just weak results IMO) as some of his other research result (such as that in the Common Risk Factors in the Returns on Stocks and Bonds). For example from the article on Update of the Research Underlying Dimensional's Bond Strategies Fama concludes “The implication of regression slopes close to 1.0 in Table 1 is that the wanderings of forward-spot spreads on average show up one-for-one as wanderings in term premiums. This is the basis of Dimensional's variable maturity strategies, and it is the source of their value added over fixed maturity strategies.” Now if we look closely at Table 1, the explanatory power of the models is very low. i.e. the variation in forward spreads explain between 2% and 13% of the variation in term premiums (much weaker than the 95% explanatory power of the FF equity factors). As a result, I’m less inclined to shift between short and intermediate term (based on these results).
Robert
.

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by matjen » Sat Mar 03, 2018 6:02 pm

Thank you Robert T. for your insights. Much appreciated.
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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Munir » Sat Mar 03, 2018 6:24 pm

Theoretical wrote:
Sat Mar 03, 2018 2:04 pm
The Vanguard Tax-Exempt "active" funds are hard to really describe as active, as they have miniscule turnover, sometimes lower even than the Muni Index, and they have twice as many holdings.

At most, by their behavior, they do a bit of yield curve positioning, but are still closet index funds.
How does one decide what is a "closet" index fund that does not strictly follow an index? Is it by the low cost, low turnover, degree of passivity or what? I'm thinking of Vanguard bond funds such as Intermediate Investment Grade (VFIDX), Short-Term Investment Grade (VFSUX), and Core Bond Fund (VCOBX)? How important is the designation of an "index" fund if such funds are closely following index funds in these parameters while not adhering to an index? (I don't know if they actually do follow these parameters or not).

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Robert T » Sat Mar 03, 2018 6:49 pm

matjen wrote:
Sat Mar 03, 2018 6:02 pm
Thank you Robert T. for your insights. Much appreciated.
I see the link doesn't work anymore. Personally, I much preferred the old DFA website. It had some of the DFA research underpinning their approach (such as the linked paper in the earlier post), and other interesting articles articles by DFA principals - http://www.prudentllc.com/sevg/PDFs/Ind ... xFunds.pdf that you now have to go elsewhere to find.

The new DFA website comes across as a sales pitch (in graphics), old DFA website provided more knowledge (to inform decisions). Now need to go elsewhere - AQR Library, or AlphaArchitect for knowledge. IMO this is unfortunate for DFA who prizes themselves on research (knowledge generation). At least we still have access to Fama-French research https://papers.ssrn.com/sol3/cf_dev/Abs ... per_id=998 , and Ken French's datasets http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/ .

Just my opinion.

Robert
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Re: Larry Swedroe: Active Fails In Fixed Income

Post by stlutz » Sat Mar 03, 2018 7:53 pm

As a result, I’m less inclined to shift between short and intermediate term (based on these results).
I've done some backtesting of this strategy just using Excel--the results of course indicate that the strategy "worked" historically. But when I looked deeper at the data, the result was very dependent on the 30 years or so around 1980--punctuated by a long period of rising inflation and interest rates and long period of declining inflation and interest rates. Those types of long-term changes very much favor the strategy. I'm not sure that I view this as the "normal" state of affairs, however.

That said, the strategy does have a definite logic to it. In fixed income I tend to agree with the saying that you shouldn't take the risk if you aren't being compensated for it. Why go further out on the curve if there is no payment for doing so? On the other hand, one could argue that going from short to intermediate term isn't actually taking more risk--you're just exchanging one risk (term) for another risk (the risk that you won't be able to reinvest at rates that are as high as they are today).
The Vanguard Tax-Exempt "active" funds are hard to really describe as active, as they have miniscule turnover, sometimes lower even than the Muni Index, and they have twice as many holdings.

At most, by their behavior, they do a bit of yield curve positioning, but are still closet index funds.
Vanguard describes their funds as active and I don't think the team of credit analysts that they pay to analyze bonds all day would say they are just buying a bond because it's for sale (which is what a passive fund would do whether it follows an index or not).

I guess I don't view "active" as an epithet. I'm mostly about low-cost investing. I'm a huge fan of actively-managed funds like Vanguard's IT Tax Exempt or Vanguard Wellington. They are low cost and they follow a consistent strategy through time. Being consistent, whether one is selecting bonds or selecting, say, value stocks is not the same thing as being passive.

If one is following the strategies that are outlined in Swedroe's bond book (which I admittedly haven't read), then you are taking a sensible, consistent approaches to bond investing. The active choices he has historically recommended are distinctly different from just buying everything with "bond" in the same.

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Re: Larry Swedroe: Active Fails In Fixed Income

Post by Robert T » Sun Mar 04, 2018 4:36 am

.
Here's a comparison that may be of interest to some. Post ended up being longer than expected.

I would consider the DFA Five-Year Global Fixed Income fund to be a fairly “active” fund. i.e. it uses a variable maturity approach (shifts the bond maturities in the portfolio as the yield curve changes), and shifts country weights to take account of yield curve differences across countries.

Initial expected premium from the DFA Five-Year Global Fixed Income Fund (from DFA)

According to this 2002 paper about 15 years ago https://www.ifa.com/pdfs/dfa_fixedincomeinvesting.pdf (see Table 7, pg. 9) the DFA Five-Year Global Fixed Income Portfolio was expected to provide 50-100 basis points in annual return premium above the Lehman Aggregate Bond Index (now the Barclays Aggregate Bond Index).
  • Annualized returns over the past 15 years

    DFA Five-Year Global Fixed Income (BFGBX) = 3.02%
    Barclays Aggregate Bond Index = 3.90%
    Vanguard Total Bond Market = 3.76%
Over this period, the opposite was true – the Aggregate Bond index provided between 50-100 basis points in higher returns (88 basis points to be specific or 0.88%) than the DFA Five-Year Global Fixed Income Fund. The Vanguard Total Bond Market fund is a close real-life version of the Aggregate Bond Index that had a 0.74% higher return over this period.

Using a benchmark with more similar risk exposure (factor loads)

To be fair, the aggregate bond index is not the right benchmark as it has different exposure/factor loads to default and term risks. Unfortunately Portfolio Visualizer bond factors only go back to Feb 2010. Using the time period since Feb 2010 the factor loads were as follows:
  • Term/default factor loads: Feb 2010-December 2017

    DFA Five-Year Global Fixed Income (DFGBX) = 0.20/0.15
    Vanguard Total Bond Market Index (VBMFX) = 0.30/0.17
    Vanguard Short-term Investment Grade (VFSTX) = 0.12/0.16
While DFGBX and VBMFX had a similar default load, VBMFX had a 50% higher term load (0.30 vs. 0.20). A 50:50 combination of Vanguard Total Bond Market and Vanguard Short-term Investment Grade gets you closer to the factor loads of the DFA Five-Year Global Fixed Income Fund (0.21/0.17 vs. 0.20/0.15 term/default loads).
  • Over last 27 years: Jan 1991 – Feb 2018: Annualized return (%)/Sharpe ratio

    5.18% / 0.91 = DFA Five-Year Global Fixed Income (DFGBX)
    5.19% / 0.95 = 50:50 Vg Total Bond (VBMFX):Vg ST Investment Grade (VFSTX)
So on a more closely factor matched based (consistent with Fama-French research) the annualized returns and Sharpe ratios over the last 27 years were similar. If anything, the Vanguard combination had a slightly higher Sharpe ratio. I would just note that even though annualized returns were similar over the full period, there were sometimes large differences in annual return (e.g. as in 2008).

In a portfolio context

Obviously it is not prudent to look at a bond portfolios in isolation as an investor is not likely to hold a 100 percent bond portfolio. If we compare each of these in a broader portfolio context using, as an example, a portfolio with 75% stocks and 25% bonds.
  • Over last 27 years: Jan 1991 – Feb 2018: Annualized return (%)/Sharpe ratio

    9.25%/ 0.66 = 75:25 Vg 500 (VFINX):DFA Five-year Global Fixed Income
    9.24%/ 0.65 = 75:12.5:12.5 Vg 500 (VFINX):Vg Total Bond:Vg ST Investment Grade
Again, similar annualized returns and Sharpe ratios. I would just note that the first portfolio had lower downside in 2008 than the second (-26.7% vs -27.7%), but both has similar max drawdowns (-39.0% vs -39.6%). If DFA US Small Value is used for the 75% stock portion, the annualized returns and Sharpe ratios are still similar across the two portfolios.

The above just demonstrates to me the power/value of the Fama-French research (as per the article linked in the OP). Most of the time, portfolio comparisons are not on a factor matched basis i.e. they compare portfolios with different risk profiles. Performance differences are then often claimed to be additional alpha (from management genius) when they are simply differences in risk exposure.


Excluding default risk

As a postscript – what would have been the result of excluding default risk in fixed income?

A 65%:35% Vanguard Intermediate Treasury (VFITX):Short-term Treasury (VFISX) portfolio had similar term risk exposure as the above two bond portfolios (65%*0.28+35%*0.06=0.20 term load)

On a standalone basis:
  • Over last 26 years (longest time period with available data) - Jan 1992-Feb 2018: Annualized return: Sharpe Ratio

    4.90%/0.86 = 100% DFA Five-year Global Fixed Income
    4.86%/0.87 = 50:50 Vg Total Bond:Vg Short-term Investment Grade
    4.85%/0.65 = 65:35 Vg Intermediate Treasury: Vg Short Term Treasury
The most noticeable difference is the lower Sharpe ratio on the Treasury portfolio which is as expected given the ‘diversification’ provided by inclusion of corporate bonds. However, this greater default risk shows up in larger max drawdowns for the first two portfolios.

But as Larry has repeatedly said – don’t look at bonds in isolation, but rather at how they fit into an overall portfolio. Here's a comparisons in the context of a 75:25 stock:bond portfolio
  • Over last 26 years: Jan 1992 – Feb 2018: Annualized return (%)/Sharpe ratio

    8.66%/ 0.62 /-26.8% = 75:25 Vanguard 500:DFA Five-year Global Fixed Income
    8.64%/ 0.61 /-27.7% = 75:12.5:12.5 Vanguard 500:Vg Total Bond:ST Inv. Grade
    8.72%/0.63 /-25.0% = 75:16:9 Vanguard 500:Vg Intermediate Treasury: Vg ST Treasury
Excluding default risk in bonds over this period did not give up anything in portfolio returns, and provided greater downside protection in 2008. A more accurate comparison would probably be to lower the stock allocation of the first two portfolios to adjust for the higher bond default risk.

Obviously no guarantees.

Robert
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