The Problem With Bond Indexes
Thursday, October 11, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 30.6%, down 3.3 points
  Neutral: 30.6%, down 2.3 points
  Bearish: 38.8%, up 5.6 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Though I believe in combining passive and active investing strategies, it is important to realize that not all indexes are the same. This is particularly the case when it comes to bond indexes. Bond indexes are harder for a manager to replicate than stock indexes because of multiple bond issues and liquidity constraints.

Most companies issue a single class of common stock. Even when there are two classes, stock indexes only hold one of the two classes. Berkshire Hathaway provides an example. The S&P 500 index holds class B shares (BRK.B), not the significantly more costly class A shares (BRK.A).

Conversely, many companies have multiple bond issues. A bond maturing in three years will have different characteristics than a bond maturing in seven years, even if both are issued by the same company. Thus, replicating a bond index is not as simple as merely adding General Electric (GE) bonds. The same issue has to be held in order to replicate the index.

Furthermore, because there can be several bond issues, liquidity can be a problem. A manager trying to track a specific bond index may not be able to buy a large enough position in a given issue to precisely track the performance of a bond index. This is particularly the case for a large portfolio or a large fund.

This does not mean bond indexes are bad, however. I personally hold the Vanguard Total Bond Market Index fund (VBMFX) in my 403(b) retirement account. Rather, it simply means that bond indexes are more difficult to replicate. Since they are more difficult to replicate, they are not as useful of a comparison tool to judge a bond manager’s performance by.

The S&P 500 serves as a useful comparison for measuring a large-cap stock manager’s performance because funds can easily replicate its composition. Since bond indexes are tougher to replicate, comparing a bond manager’s performance to them is often not an apples-to-apples comparison. A bond manager’s portfolio may have different maturities, duration (a measure of sensitivity to changes in interest rates), yield or credit quality. All of these can impact comparative performance.

This is not to say that you should avoid comparing an active bond manager’s performance against that of an index, but rather that you should consider using more than one measure. Add to the mix comparable bond funds (e.g., U.S. long-term general bond funds) to provide a broader base of benchmarks. Plus, consider whether there are reasons beyond the manager’s talent (or lack thereof) playing a role.

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The Week Ahead

Approximately 80 members of the S&P 500 will report earnings next week. Included in this group will be Dow components Coca-Cola (KO), Intel (INTC), International Business Machine (IBM), Johnson & Johnson (JNJ) and UnitedHealth Group (UNH) on Tuesday; American Express Company (AXP) and Bank of America (BAC) on Wednesday; Microsoft (MSFT), The Travelers Companies (TRV), Verizon (VZ) on Thursday; and General Electric (GE) and McDonald’s (MCD) on Friday.

On the economic front, September retail sales, the October Empire State Manufacturing Survey and August business inventories will be announced on Monday. Tuesday will feature the September Consumer Price Index (CPI), September industrial production and capacity utilization, and the October National Association of Home Builders housing index. September housing starts and building permits will be announced on Wednesday. Thursday will feature the October Philadelphia Federal Reserve survey and September leading indicators. September existing home sales will be announced on Friday.

The Treasury Department will auction $7 billion of 30-year inflation-protected securities (TIPS) on Thursday.

October stock options expire on Friday.

AAII Sentiment Survey

Optimism fell to a 10-week low as pessimism rose to its highest level since late July in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 3.3 percentage points to 30.6%. This is the lowest level of optimism since August 2, 2012. It is also the seventh consecutive week and the 27th out of 28 weeks that bullish sentiment is below its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 2.3 percentage points to 30.6%. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, jumped 5.6 percentage points to 38.8%. This puts pessimism at an 11-week high. Bearish sentiment is above its historical average of 30% for the seventh consecutive week and the 23rd out of the last 27 weeks.

Bullish sentiment and neutral sentiment have only been at equal levels 28 times over the history of the survey. The last time both bullish and neutral sentiment were equal was November 5, 2009.

Four days of declines have dampened optimism about the short-term direction of stock prices and increased concern among those worried about a potential forthcoming pullback. Many individual investors remain focused on slowing global economic growth, Washington politics and the European sovereign debt crisis. The potential outcome of the presidential election is also impacting some investors' sentiment. Those who are optimistic about the short-term outlook are encouraged by improved economic data and this year's rise in stock prices.

This week’s special question asked AAII members for their perception of the housing market. Specifically, we asked whether or not the housing market is starting to recover. Most respondents said, yes, the housing market is starting to recover, but many added the caveat of a slow and prolonged recovery. There were also some individual investors who thought the housing market is merely bouncing along the bottom or still has the potential to worsen.

Here is a sampling of the responses:

  • “The housing market is starting to recover, but it will take several more years before people’s confidence returns.”
  • “Housing may be recovering, but there are still a lot of foreclosures coming to the market.”
  • “I am seeing a swing upward, especially here in the San Francisco Bay area of California.”
  • “I think it is starting to recover, but at lower prices.”
  • “I believe prices will rise slowly and that low mortgage interest rates will help, but the market will be mostly stagnant because banks are unwilling to lend.”
  • “I don’t think so. Too much shadow inventory and strict regulation on credit. People may have enough income to qualify for a loan, but not the credit rating or down payment.”

» Take the sentiment survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor