Not All Total-Bond-Fund Bond Index Funds are Alike

Tuesday, April 30, 2013 at 11am
By John Friedman

I read Morningstar’s annual report the other day, and saw something interesting in there: Morningstar’s business is being hurt by the rise of passive investment approaches and the mirror-image fall of active investment approaches.

That makes sense, right? After all, Morningstar helps folks be better informed about, primarily, mutual funds, and most mutual funds are about, primarily, active investing. So when passive is ascending and active is descending, that spells trouble with a capital T for morningstar with a capital M, right?

It also makes sense because quite a few people think that excellent mutual fund picking, like excellent stock picking, can be had via digging-in and doing the heavy-lift research, so as to divine which fund is likely to have the hot hand for the next umpty-ump years (is that future hot hand more likely to be attached to the fund with the hot hand right now, or the fund attached to the cold hand right now? Hmmm . . . . )

And that’s where Morningstar comes in: they help people research mutual funds, ranking them from 1 to 5 stars, with, to some folks’s surprise, 5 stars being really excellent (and rare), and 1 star being really terrible (and also rare).

So when passive investing — the opposite of active investing — is romping throughout the investing landscape and frolicking in the autumn mist, that’s bad for Morningstar’s business.

And so it was said, within M-star’s annual report Overview (yes, the Overview has no page numbers):

The investment industry continues to face challenges as assets flow to passive and fixed-income products.

 

as well as this in the Letter to Investors (Page 4):

It’s no secret that 2012 was a challenging year. In addition to a lackluster global economy, the investment industry has been hurt by low interest rates, client risk aversion, and increased regulation. And, for many firms, the popularity of passive products and alternative investments is a major challenge. This often leads to lower revenue expectations and higher expenses, so asset managers and brokerage firms tighten their belts. For us, this means longer sales cycles and smaller price increases. It’s also tough to get clients to try new providers.

 

Apparently lawyers like the liability-containment characteristics embedded within the DNA of the word-family-tree, challenge/challenged/challenging, eh!?

And then there was this, too, addressing a fall-off in the part of their business tied to traffic on its website (Page 11):

Meanwhile, the popularity of passive and fixed-income investments means less interest in research on stocks and actively managed funds. Nevertheless, our site continues to garner positive reviews.

 

What I think happened here is that M’star wanted to say that its website business had also been challenging, but that it shied away from doing so because its analysis of the remaining inventory of the challenge/challenged/challenging sibs led it to conclude that it was best to not narratively sup at that particular word-family’s trough again. 

So everywhere it looks, M’star sees passive investors and their diminished interest in all the data M’star has collected, coddled, coagulated and collated (and sometimes simply purchased, e.g. the Ibbotson data) and which it now sells.

Full disclosure: I am a shareholder (that’s why I had the annual report handy . . . ). I think a lot of Morningstar, though less than I once did, and these days I am mostly selling off my single stock holdings in favor of . . . passive investments! So the M-star shares might be vamoosed soon.

*  *  *

The other day I was doing some portfolio design work with a client and we were looking at Schwab’s passive index U.S. bond offerings. For reasons I won’t bore you with, we wanted something from Schwab to fill that role other than SCHZ, its very groovy, very free-to-trade-at-Schwab ETF designed to track the entire American bond market.

So we were looking at SWLBX, Schwab’s Total Bond Market mutual fund, using Yahoo Finance as our main tool (Google, you were too late; the old dogs — me, anyway — had already learned how to do what they needed to do on Yahoo Finance, so our imprinting was complete and the bonding was cured by the time you came along).

And there I was, doing what I normally do, which is to do a quick check of this unknown-quantity/stranger-fund against other known quantities, such as VBMFX, which is Vanguard’s similarly named fund, when, with but a few clicks, good golly Miss Molly did I ever see something that surprised me.

First I saw this (all pix scraped from Yahoo Finance on 4/15/13):

Share Price of Schwab Total Bond Fund vs. Vanguard Total Bond Fund, over previous one year time period

Share Price of Schwab Total Bond Fund vs. Vanguard Total Bond Fund,
over the most recent one-year time period

 

That looks about right: the green line, which represents the Vanguard fund, is closely tracking the blue line, which represents the Schwab fund, and vice versa (necessarily vice versa, right? — both are tracking the same thing, which is the overall American bond market, so they should both behave the same). But there was enough discrepancy, particularly towards the recent, right side of the graph, that I wanted to see more.

So I dialed in a two-year time frame and this is what I saw:

Share Price of Schwab Total Bond Fund vs. Vanguard Total Bond Fund, over the most recent two-year time period

Share Price of Schwab Total Bond Fund vs. Vanguard Total Bond Fund,
over the most recent two-year time period

 

Again, it’s pretty tight, but, also again, the more recent time period shows a lot more disparity than the older time period, to the left of the graph, which is tight as a drum. My curiosity was piqued (to say the least), though not yet even close to peaked. So I dialed in a five-year time frame and this is what I saw:

Share Price of Schwab Total Bond Fund vs. Vanguard Total Bond Fund, over the most recent five-year time period

Share Price of Schwab Total Bond Fund vs. Vanguard Total Bond Fund,
over the most recent five-year time period

 

And that made me do a Huckleberry Hound Dog double-take. What on gosh’s green earth happened in 2008? Yes, September the 15th happened, with Lehman going bust and the credit markets kvetchin’ and a’ retchin’, but this is a side-by-side comparo of two passively invested total bond funds, both designed to reflect the entire American bond market, in all its many facets — warts and pimples and zits and all, as well as beautiful eyes and high cheekbones and slim waists and all — and which should both, therefore, presumably, be quite similarly impacted. Both, after all, are designed to reflect the good, the bad and the ugly of the American bond market.

Yet there is the Schwab fund (the blue line) taking a much bigger hit to its share price and never recovering versus the Vanguard fund (the green line).

Stunned and staggered, I went there and dialed in the maximum time-frame version — the longest time-frame Yahoo Finance’s static chart tool (the old, scrapable version) was willing to serve up, and this is what I saw:

 

Share Price of Schwab Total Bond Fund vs. Vanguard Total Bond Fund, over the maximum most recent time period Yahoo Finance has to offer up on April 15, 2013

Share Price of Schwab Total Bond Fund vs. Vanguard Total Bond Fund,
over the maximum most recent time period Yahoo Finance offered up on April 15, 2013

 

Pretty vivid, eh? Both funds are supposed to be tracking the exact same single thing, but they are so very different at that one point in time that, clearly, one or the other of them — or perhaps both? — failed to track that one single thing.

*  *  *

So say you own $10k of each fund, and say that you’re going along and you’re going along, and they are always within a nit on a gnat’s knee’s distance from one other, in near-perfect lockstep, so that when one is up to, say, $12,345, the other is up to, say, $12,456 or so, and they are really tightly tracking each other, but then one day, when the markets are going crazy in the fall of 2008, all of a sudden, after years and years of tracking each other snug as a bug, one of them loses 13% of its value while the other is losing just 3% of its value. Kaboom!

Your $12,345 worth of the one fund goes all the way down to $10,740.15 (that’s the 13% loss) and your $12,456 of the other fund goes down to $12,082.32 (that’s the 3% loss), with the former losing $1.6k and the latter losing about $375.

And say that all of that happens in the course of a few weeks, and that, once that big divergence is over, from then on things go back to the way they were, with the two funds tracking each other snug as bugs are snug, never more than a nit-gnat’s-knee’s difference between what they do each day, but always and forevermore with that 10-plus-percent delta between them. So where once they danced the tightest of tangos, now they peer at each other across a wide chasm, two lovers never again to touch.

So remember, all you passive investors out there: not all passive portfolios behave the same, and this is true even when the passive portfolios are supposed to be passively tracking the same thing.

*  *  *

Oh yoohoo! Yoohoo! Oh Morningstar! There is still plenty for you to say about funds, even if they do all end up being passively managed. Because, as it turns out, one or more of them will fail at tracking their chosen target — one or more of them will end up having some wriggle room in their target that no one would’ve guessed was there, given their name and their marketing materials.

Which is not to say that I’m sanguine about your business, M’star. The passives are a’risin! Maybe you all should be thinking about buying an ETF-data house?

*  *  *

Note to wonkish readers and rocket science money guys and gals: do you know what caused the divergence? I haven’t the time to dig into it.

Did Schwab have auction rate securities in there? Dunno. But if they did: gosh!

Or maybe it was some sort of weird distribution that the Schwab fund made but as to which Vanguard did nothing even remotely similar? That can make for some big, unilateral downdrafts in the price of the shares of the fund. That might be easy enough to look into . . . but I haven’t the time or desire to do it.

My hunch and gut — and it’s only that — is that Schwab larded up its total bond fund with something that proved to be . . . unbecoming . . . let’s call it. But that’s probably my pro-Vanguard, suspicious of Chuck approach to the Financial Services Industrial Complex generally.

Clearly Schwab had some nasty potion of some kind in its fund that Vanguard did not — something that led to the Schwab fund having to digest something that the Vanguard fund did not.

But all of this begs the real question here: which fund best represented the American bond market?

Surely some fixed income folks know the answer to this question off the top of your heads. Me? I’m the generalist. Any specialists out there who can lend a hand? Any bond gurus who can shed some light on this apparently permanent delta?

At least one inquiring mind wants to know. Thanks for any insights you can provide!

 

 

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  1. Posted by Hubert on Thursday, May 23, 2013 at 4am
    Good info. Lucky me I discovered your blog by accident (stumbleupon).
    I've saved as a favorite for later!