In an interview with Salim Ramji, Vanguard’s new CEO, he told me, “We have an outstanding active fixed income capability.” I followed up with Vanguard and wasn’t surprised that their active bond funds had bested peers since they have much lower fees. But I was shocked when they gave me the following data as of November 30, 2024 showing the vast majority of their active bond funds had bested their benchmarks since their benchmarks have no fee.
Vanguard claims that, over the past five years, 92% of their active bond funds have bested their benchmarks. That is to say, 86% of taxable bond funds and every municipal bond fund more than covered their costs to beat their perspective benchmarks.
A Vanguard spokesperson explained why active investing works better for bonds than it does for equities. She noted that bond indexing has a lower market share of ’40 Act funds and stated there were a number of factors that create opportunity to capture excess return in the complex and relatively opaque fixed income market.
1. Many different bonds with various characteristics (e.g., coupon, maturity, price, capital structure, optionality) represent the fixed income portion of an issuer's capital structure. However, for most public companies, there is only one equity offering. This translates into a greater number of decision points for an active team to add value.
2. Much of the fixed income market still trades over-the-counter, which creates inefficiencies in pricing and liquidity.
3. Given the high number of outstanding bonds across a large swath of issuer types, benchmarks do not cover the full universe of outstanding bonds (as is the case for equities). This creates an opportunity for active managers to add attractive off-benchmark exposures to a portfolio to add value.
4. Noneconomic buyers (such as central banks), that need to have exposure to certain parts of the fixed income market, are not necessarily seeking to maximize returns. These buyers nonetheless influence supply and demand dynamics in fixed income markets, which can create relative value opportunities for active managers to exploit.
Always the skeptic, I wasn’t about to accept this at face value. I’ve heard the claim before that indexing doesn’t work in bonds. Take the Vanguard Total Bond ETF (BND), which follows the Bloomberg US Aggregate Float Adjusted Index. It successfully followed the index closely, underperforming mostly due to fees (currently 0.03% annually), but it was bested by 59% of its peers over the past 15 years ending December 27, 2024. Many have declared that this proves indexing doesn’t work for bonds. I disagree.
While the durations of the Vanguard fund and its peers are similar, credit quality is very different, as can be seen below from Morningstar.
The category peer group had well under half the AAA-rated (mostly U.S. government) bonds that BND held and some junk (below BBB) and nonrated bonds. In my book, this is not alpha – this is taking on more default risk that I classify as beta.
Is Vanguard doing something similar with its own actively managed bond funds? I looked at the Vanguard Core Bond Fund (VCOBX) and found it follows the same benchmark as BND. Vanguard shows it outperformed. Over the five-year period ending November 30, 2024, this active fund bested the Bloomberg US Aggregate Float Adjusted Index by 69 bps annually. This fund currently has a 0.10% annual expense ratio, so after those fees, it added this 0.69% alpha annually. Was it really alpha?
What I found is that this active bond fund had far less AAA than the index but more than the Morningstar peer group. Morningstar shows it bested about 84% of its peers over the past five years despite having higher credit quality.
I spoke to Jeffrey Johnson, a Vanguard principal and head of fixed income product. He provided me the following five attributions of outperformance of this fund over a five-year period. This was for the five years ending December 31, 2023, and these were arithmetic averages, so they won’t add to the 69 bps average mentioned previously:
Johnson further defined the five attributions as follows:
Total Credit Allocation: Outperformance that comes from the credit risk premium, or positioning the fund to have more credit risk than its benchmark.
Credit Sector Allocation: Choosing how the fund is allocated across the broad fixed income sectors (e.g., investment-grade corporates, high yield corporates, emerging markets, structured products). For example, the team may choose to overweight investment-grade corporates over other sectors.
Security Selection: Picking the right bonds to hold, and in certain proportions relative to the bonds in the benchmark.
MBS: Outperformance from mortgage-backed securities exposure overall. This includes picking the right securities to own and making the right decision on whether to be overweight or underweight relative to the benchmark.
Rates: Outperformance that comes from positioning of the fund’s overall duration risk or its exposures along the curve relative to its benchmark.
Johnson explained that these numbers should be considered approximate attributions.
My take
I’m not ready to concede that active bests the benchmarks by adding what I consider alpha. For example, “positioning the fund to have more credit risk than its benchmark” is a risk premium much in the same way that the equity risk premium produced returns over the risk-free rate. The credit risk premium may be worth it, but that’s beta, not alpha. Lower credit quality bonds have a higher correlation to stocks. And William Sharpe’s arithmetic of active management should work just as well in fixed income as it does in equities. We can’t all be above average, especially after fees.
Benchmarking is an imperfect science. For this Vanguard Core Bond Fund, I know of no single benchmark better than the Bloomberg US Aggregate Bond Index, but clearly the bond fund has more credit risk than the index. Using a weighted average benchmark of securities including Treasurys, GNMAs, investment-grade corporates, and junk defeats the whole purpose of benchmarking and creates more ways to game benchmarking
But I was also impressed with Johnson’s descriptions of a very disciplined bond management process combined with low fees, and I put my toe in the water. I sold some of my total bond fund and bought the active core bond fund. After all, for decades I’ve been using quite a bit of active fixed income investing by buying individual Treasurys, CDs and TIPS and by building TIPS ladders along with my bond index funds. I tell clients to keep credit quality high and duration no more than intermediate (except for individual TIPS held until maturity). Always keep fees low.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisory firm. He has been working in the investment world of corporate finance for over 25 years. Allan has served as corporate finance officer of two multibillion-dollar companies and has consulted with many others while at McKinsey & Company.
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In an interview with Salim Ramji, Vanguard’s new CEO, he told me, “We have an outstanding active fixed income capability.” I followed up with Vanguard and wasn’t surprised that their active bond funds had bested peers since they have much lower fees. But I was shocked when they gave me the following data as of November 30, 2024 showing the vast majority of their active bond funds had bested their benchmarks since their benchmarks have no fee.
