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"Bonds Are Different:" "Active have largely outperformed passive after fees"

"Bonds Are Different:" "Active have largely outperformed passive after fees"

| November 05, 2020

"Why ... ?" is the obvious question. (Why have active bonds outperformed passive?)

Fans of logic and arithmetic, please read more ... 

What Is a Capitalization-Weighted Index?

"A capitalization-weighted index is a type of market index with individual components, or securities, weighted according to their total market capitalization. Market capitalization uses the total market value of a firm's outstanding shares. The calculation multiples outstand shares by the current price of a single share. Outstanding shares are those owned by individual shareholders, institutional block holdings, and company insider holdings"Source: Investopedia

How many items are in the S & P 500 Index? 500 (approximately) 

Let's start fairly simply and say, 500. Approximately. Another short answer: consult with S & P. Why approximately? Because each index provider has their own way of adding items to their index. And, sometimes, subtracting. One simple example, when one public company in the S & P 500 is bought by another one, what happened to the number of items? It went from 500 to 499. (If it was 500 before.) And then, it stays at 499 until S & P uses their own proprietary process to add an item to its index. Then, back up to 500. What happens if an S & P 500 firm splits itself into two firms. My guess: 501. That guess assumes that both of the new firms stay in the S & P 500. But that would be up to S & P.. Logical, but not carved in granite!

Now, a reminder from Prof. William Sharpe about why passive works .... can work .... especially with stocks and especially with relatively small numbers of stocks ...

My commentary

I think the above statement might be helped by a bit of opinion and commentary. A reminder from immediately below is that the S & P 500 is a cap-weighted index. So we know what items are in it -- the S & P 500. And the cap-weighting tells us how much of each item is in it. Which, by definition, probably can and will change every day the market is open as prices can and typically do change daily for many if not all of the items.

Let's keep things restricted to make them easier to understand.

An active manager in the S & P 500 (aka "Large Cap Domestic") "space" could outperform (or underperform) the index by owning the 500 items in differing amounts than the index. And or choosing not to own all 500, just certain ones. Etc.

In this informal "competition" between active and passive, we might opine that everyone is playing the same game on a level playing field.

And, as Professor Sharpe noted, the active managers as a whole, like the passive managers, hold the market portfolio. Both groups, on average, will generate the same return before fees. To the extent that active fees are higher, on average the passive managers will outperform.

Do we have broad logical agreement?

How many items are in a large Bond Fund or ETF? (e.g. Vanguard Total Bond Market ETF?) 9908

What? 9908?!!

Please see attached BND Client Fact Sheet of Sept. 30, 2020. Again, as I mentioned before, "approximately." Why. Because bonds can be redeemed by the issuer. And any material from a sponsor that is printed - paper or digital, is obviously printed at a point in time. With nearly 10,000 items in this ETF, I speculate with some logic that the number of them have to fluctuate for this and other reasons.

My own opinion: "Apples & Socket Wrenches"

An "index" with 9908 items in it is hardly an index at all. Serious readers who want to delve into this topic further will also notice in Point # 5 of the 12 points that "most equity indexes are rebalanced annually or quarterly. The annual turnover rate of the S&P 500 index was about 4% ... Conversely, 

Sharpe's arithmetic implicitly assumes passive investors buy and hold and don't trade securities. In reality, most bond indexes are rebalanced monthly ... "The average turnover rate for the Bloomberg Barclays US Aggregate Bond Index for the past 3 years was about 30% ... (as of 31 Dec 2016.)"

While we might be getting far afield, I feel what is going on is fairly obvious. We're not talking here about "apples & oranges." We're talking about "apples & socket wrenches!"

The rest of the PIMCO material attached below is instructive. Broadly, I feel it supports my own thinking. Traditionally, equity investors and money managers looked for "mispricings."  But in the equity space there is the emotional element of popularity. In theory, bonds are "just numbers." But PIMCO's discussion about "non-economic investors" I also find quite instructive. Read it for more info.


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