Why faster internet and bond ETFs may not be good for you

Do you remember what life was like prior to high-speed internet? I re-watched You've Got Mail recently and was reminded of the torturously slow modem beeping and screeching its way onto the Internet. Meg Ryan was overly excited to hear the antiquated notification "You've Got Mail" when one email arrived, but nowadays your inbox is so inundated with emails that you're only excited if it isn't a bill or spam.

What was life like prior to the invention of bond ETFs? Well, unlike stocks, bonds were off-limits to the average investor. The minimum size of bond purchases was US$100,000 or more, which excluded small investors from investing directly in the bond market. Individual bonds were traded directly between broker-dealers and large institutions, and this meant that prices were much less transparent than stocks, which are traded on public exchanges. The over-the-counter nature of the bond market favoured larger and more sophisticated investors.

Life post bond ETFs: passive bond indexing and the introduction of bond ETFs have levelled the playing field for you and me. Bond ETFs can be traded like stocks on an exchange, which means that their prices are more transparent compared to individual bonds. We can choose to get broad-based exposure to the bond market by tracking major benchmark indices such as the Bloomberg Barclays Global Aggregate Index, or narrower segments of the market such as short-term German government bonds.

Unfortunately, if you scratch beneath the surface, it's not all rosy in the world of bond index ETFs. Just like how having faster internet has caused us to spend too much time surfing Instagram, there are certain structural challenges in investing in bonds passively through index ETFs.

1) Size and complexity of bond market

There are ~344,000 securities in the bond market compared to ~14,400 in the stock market for the representative global index. Due to the size and complexity of the bond market, passive ETFs will invest in an optimized sample of securities as full replication of the underlying benchmark is not practical or cost-effective. For example, the Bloomberg Barclays US Aggregate Index includes more than 10,054 securities while the leading ETFs that track the index include only ~29-73% of those securities. Passive fixed income ETFs are actually making active decisions daily to replicate its benchmarks.

2) Buying more of the worst

Just like in equities, bond indexes are typically market capitalization-weighted using the outstanding market value of bonds. This makes sense in equities where large index-weighted companies also tend to also be the largest and most successful companies. However, in bond indexes, the companies with the highest amount of debt have a higher weighting. This means you are holding more of a company's debt as it becomes more leveraged - it's essentially buying more of the worst.

3) Finite life of bonds

Bonds have a maturity date, which means that there will constantly be bonds maturing and new issues launched, compared to the perpetual nature of stocks. As a result, bond indexes are reconstituted more often which creates higher transaction costs.

4) Illiquidity

Parts of the bond market are illiquid and may not trade for days or even months. Smaller bond issues may not have an active secondary market. Bonds also become more illiquid as they approach maturity. This again leads to higher transaction costs and makes it more difficult to replicate an index.

5) Lag in credit ratings

Bond indexes use official credit ratings from rating agencies such as S&P, Moody's and Fitch, to categorise bonds in sub-asset classes (i.e. AAA, AA, BBB, etc, investment grade or high yield). There is often a lag in the rating agency's upgrade or downgrade of a bond versus the underlying issuer's change in credit fundamentals, whereas the market is well-ahead in pricing it in. This means that the passive index fund will buy or sell bonds late in the game.

Industry research has focused on the argument for passive over active in the equities space. Not much discussion has revolved around whether investors enjoy the same benefits of passive investing in the fixed income space. Bond ETFs have democratized access to an asset class that was previously hard to for the average investor to invest in, but there are inherent structural challenges in passive bond investing. Passive funds for many fixed income categories have consistently wider tracking error and underperformance versus their respective benchmarks, especially when compared to passive equity funds or ETFs. In fact, historical performance shows that certain active managers have consistently been able to beat benchmark returns over the long-term. The number of active managers who beat the benchmark is significantly higher for fixed income than in equities. Just like having faster broadband access doesn't necessarily lead to higher productivity in your life, access to the bond market through bond index ETFs may not be the solution to our investment problems.