Portfolio perspectives

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Portfolio perspectives

Vanguard Perspective

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March 22, 2024

Each month, you'll have access to the latest insights from our Portfolio Solutions experts to help you address evolving issues that may affect your clients' portfolios.

 

Matthew Sheridan, CFP®, CPM
Vanguard Portfolio Solutions
Matthew Sheridan, CFP®, CPM

Matthew Sheridan, CFP®, CPM

Vanguard Portfolio Solutions

Rob Dziuba, CIMA®
Vanguard Portfolio Solutions
Rob Dziuba

Rob Dziuba

Vanguard Portfolio Solutions

Bond Index Funds

The truth about bond index funds: Debunking common misconceptions

One common misconception floating around these days is that bond index funds are too concentrated in overly indebted issuers, ultimately increasing credit risk in advisor portfolios. Although it is true that market-cap-weighted bond indexes reflect total issuer outstanding debt, what's often overlooked is the size of each issuer’s debt relative to its assets and income.

Additionally, given that these indexes are market-cap-weighted, the price of the index reflects all market participants’ views regarding the relative value of all bonds trading in that market (inclusive of default risk price adjustments). Said another way, if issuers borrow above their capacity to repay their debts, their credit ratings and bond prices would be negatively impacted. That would drive their respective market-cap-weighted positions lower (not higher) in the index. So, a bond’s creditworthiness is best determined by its credit rating, not its weight in an index.

Fixed income indexes are broad and well-diversified

Consider that the Bloomberg U.S. Aggregate Float Adjusted Index (U.S. Agg), which measures the investment-grade bond market, holds more than 13,000 bonds spanning the Treasury, corporate, mortgage-backed, commercial mortgage-backed securities (CMBS), and asset-backed securities (ABS) markets. This is a far cry from an overly concentrated investment option for your clients’ portfolios.

The same type of diversity holds true when digging deeper into specific segments of the bond market. For example, the Bloomberg U.S. Corporate Bond Index (roughly 27% of U.S. Agg), which measures the investment-grade, taxable corporate bond market, holds more than 7,500 bonds.

Even if you were to aggregate all individual bonds up to the issuer level in the Vanguard Total Corporate Bond ETF (VTC), investors are diversified across more than 800 companies with less concentration than comparable equity solutions (see Figure 1). A few examples of top bond issuers in VTC are JPMorgan Chase, Apple, Oracle, Pfizer, and UnitedHealth Group.

 

Figure 1: How fixed income concentration compares to equities

Domestic equity vs. corporate bond index concentration (aggregated on issuer level, as of January 31, 2024)

Alt text for Figure 1: Bar charts showing concentration levels, aggregated on the issuer level, for Vanguard Total Corporate Bond ETF and Vanguard Total Stock Market ETF. For the top 10, here are concentration levels: Vanguard Total Corporate Bond ETF (16.27%), Vanguard Total Stock Market ETF (28.09%). For the top 100, here are the concentration levels: Vanguard Total Corporate Bond ETF (58.48%), Vanguard Total Stock Market ETF (61.44%).

Source: Vanguard.

Investment-grade fixed income indexes are just that—investment grade

Overlooking these truths may increase the probability of facing unintended consequences. In 2023, our Portfolio Analytics & Consulting Group analyzed 1,178 advisor fixed income portfolios, which were then ranked by active fund exposures. The portfolios in the top quartile (more active-based) had an average exposure to below investment-grade credit (high yield) of 18.85%, while the portfolios in the bottom quartile (more index-based) had an average exposure to high-yield of just 1.04%.

The reality is that advisors who favor index funds tend to have higher credit qualities (not lower) compared to their peers. As a result, advisors are more likely to decrease concentration risk and increase credit quality by using bond index funds.

Next steps to consider: Understand the trade-offs

Like anything in portfolio construction, there's no one-size-fits-all solution and there's no “perfect” portfolio. There are tradeoffs to any decision you make: Excluding or including bond index funds is no different.

Vanguard fixed income index funds provide your clients with straightforward bond market exposures at extremely low costs. Additionally, these indexes tend to be high quality and investment-grade-focused. That provides increased diversification benefits to your clients’ multi-asset-class portfolios. Index funds you may want to consider include: Vanguard Total Bond Market ETF (BND), Vanguard Intermediate-Term Bond ETF (BIV), and Vanguard Total Corporate Bond ETF (VTC).

Vanguard active bond funds, however, can purchase bonds of varying qualities, which over the long-term can provide your clients with higher returns, albeit with more credit risk. If these funds are thoughtfully selected, paired, and sized in clients’ portfolios, expected total returns may improve. Active funds you may want to consider include: Vanguard Core Bond Admiral Shares (VCOBX), Vanguard Core Bond ETF (VCRB), Vanguard Core Plus Bond Admiral Shares (VCPAX), and Vanguard Core-Plus Bond ETF (VPLS).

No single strategy or solution works for all scenarios, which is why pairing active and passive bond funds together can be the most practical solution for your clients’ portfolios.

Source: Vanguard, as of January 31, 2024.

Large-Cap Growth

Large-cap growth deserves another look

For many years now, the concentrated leadership of a handful of large-cap growth companies has been a dominant narrative in assessing the overall market’s health and performance. Looking back over the last few years, we saw a substantial drawdown in large-cap growth in 2022 as the Federal Reserve began its rate-hiking cycle in March of that year. Then, in 2023, large-cap growth significantly outperformed, so much so that 72% of S&P 500 components underperformed the index (source FactSet) with much of the market’s positive return coming from a handful of large-cap growth names yet again.

The “Magnificent 7” (the top seven growth companies in the S&P 500: Apple, Microsoft, Google, Meta, Amazon, Tesla, and Nvidia) have been a significant performance driver in that large-cap growth category, both in terms of returns and earnings growth. Indeed, the Magnificent 7 delivered 95% earnings per share (EPS) growth when assuming equal constituent weighting versus 15.07% for the S&P 493 over the last three years (source: Morningstar, Inc., as of March 7, 2024). Those seven companies have delivered significant earnings to help support their more elevated valuations.

Growth is more than the Magnificent 7

Much of the conversation among investment professionals has focused on whether the large-cap growth part of the market—which the Magnificent 7 dominates—is overvalued and therefore should be underweighted. Reasons cited include market concentration and multiple expansion. Vanguard believes that over the next decade value has a higher probability of outperforming growth given starting valuations among other factors. But we also believe that investors shouldn't stop participating in the growth part of the market. Higher valuations and market concentration can persist for long periods of time. That said, you'd be well-served to keep a close eye on how much your portfolio weights are drifting away from favoring any type of style tilt.

Our team collects portfolio allocations from thousands of advisors and studies how advisors are changing their discretionary models over time. Our findings were that:

  • In 2021, advisors were well-balanced between growth and value in equities.
  • In 2022, we observed advisors shift away from growth and allocate more toward dividend- and some value-oriented equities.
  • We see that lean away from growth equities stay in place since 2022 despite market-cap-weighted indexes growing in their allocation to large-cap growth equities. In fact, Figure 2 shows the average advisor is meaningfully underweight large-cap growth equities by –12.1% in their model in favor of small-cap value equities.

Figure 2: Most advisors are underweight large-cap growth

Average advisor over-/underweights compared with the FTSE Global All Cap Index

 

  Value Blend Growth Total
Large -3.2 -1.8 -12.1 -17.1
Total 2.5 5.7 -8.2  
Mid 2.1 3.2 1.2 6.5
Small 3.7 4.3 2.6 10.6

 

Notes: The figures in the perimeter show the sum of either the row or column.

Source: Vanguard data on advisor models, as of December 31, 2023.

Next steps to consider: Check your large-cap exposure

While Vanguard has identified value as having a higher likelihood of outperforming growth equities over the next 10 years, our models continue to participate in large-cap equities. As you accumulate multiple products in such categories as value, dividends, and quality, be sure to check your portfolios' tilts so you can feel comfortable with the amount of active exposure you’re taking on versus the market—especially in relation to your growth allocation. To learn more about how Vanguard can help you measure your style drift, reach out to your Vanguard representative or try our online Portfolio Analytics Tool.

If your clients are seeking a large-cap growth holding, check out Vanguard Growth ETF (VUG)

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Vanguard perspectives series

For more expert insights, check out:

  • Market perspectives: Turn to Vanguard's senior economists each month for projected returns and monthly economic highlights on inflation, growth, and expected Fed actions.
  • Active fixed income perspectives: View our quarterly, in-depth commentary for a sector-by-sector analysis and a summary of how those views affect the Vanguard active bond funds.
  • ETF perspectives: Get the latest ETF trends and insights from our investment experts to help you address issues that may affect your clients' portfolios.

 

Notes:

  • For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • Vanguard Core Bond ETF and Vanguard Core-Plus Bond ETF are not to be confused with the similarly named Vanguard Core Bond Fund and Vanguard Core-Plus Bond Fund. These products are independent of one another. Differences in scale, investment process, and underlying holdings between the ETFs and their mutual fund counterparts are expected to produce different investment returns by the products. To obtain a prospectus for Vanguard Core Bond Fund or Vanguard Core-Plus Bond Fund, please call 800-997-2798.
  • All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
  • While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.