In fixed income, index investing is far more challenging than it may seem at a glance. In a recent paper, members of the T. Rowe Price team broke down the difficulties within indexing for core fixed income ETFs. While many core fixed income ETFs track the performance of the U.S. Aggregate Bond Index, T. Rowe argues that the popular index faces key structural issues.
Namely, T. Rowe highlights how the Agg is heavily weighted in U.S. Treasuries and government-backed mortgage bonds. While these sectors provide low equity correlation and high credit quality, this comes at the expense of yield and interest rate sensitivity.
Along with sector weighting concerns, the Agg is comprised of well over 10,000 issues within the index, making full replication an impractical choice. Additionally, T. Rowe notes that some portions of the index have a misbalance of risk/reward, making the index difficult to replicate with passive investing.
“Given that full index replication is unfeasible, most passive fixed income ETFs seek to replicate the index with a smaller set of bonds using various quantitative methods. However, imprecision with any of the three major risk factors for bond indexers—duration, yield curve, and credit spread risk—causes tracking error versus the benchmark, which is impossible to fully avoid. These challenges and fees cause core bond index funds to routinely lag the benchmark—sometimes by large degrees,” T. Rowe Price noted.
An Active Option
For investors seeking to harness the Agg’s risk profile while benefiting from index inefficiencies, the T. Rowe Price QM U.S. Bond ETF (TAGG) may be a valuable option. The fund is actively managed and aims to outperform the Agg’s return by prioritizing more efficient market segment and capitalizing on the index’s inherent structural challenges.
To do so, the fund focuses investment toward intermediate-duration corporate bonds, which can produce better risk/return than longer-term options. TAGG also increases asset allocation to securitized credit sectors to seek long-term risk-adjusted returns. To balance out the portfolio duration, TAGG also purchases longer-term treasuries.
Despite the Agg’s complicated landscape, TAGG’s active management enables T. Rowe Price to efficiently seek outperforming bonds that passive indexing may miss. Broadly speaking, an actively managed fund can also more efficiently adapt to growing market trends. This is coupled with a net expense ratio of only 0.08%, far lower than many of its passively managed peers.
“Although the fund uses a quantitative security screening process, a key input is our analysts’ fundamental views on issuers and securities. We believe this is a better approach than simply buying whatever the index holds without regard for fundamentals or valuations,” T. Rowe Price added.
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