Morningstar - Q2 2023 - 8

Dispatches
Return-Free Risk
Bond index shops let
investors down in 2022.
PHILLIPS CURVE
Don Phillips
Bond-fund investors will long recall 2022 as their
annus horribilis. Sure, fixed-income funds have
had the occasional blowup, like a rare money
market fund breaking the buck, the implosion of
some derivatives-laden U.S. government funds
during the financial crisis, or a liquidity crisis
among municipal-bond managers who dabbled
with too-thinly-traded securities. For the most part,
though, a multidecade trend of declining
interest rates and low inflation had bolstered
returns and covered a lot of sins. But as long
Treasury yields sank to 1.5% in late 2021 and with
money market funds having to rebate their
fees just to maintain a positive yield, there was
clearly little to no value left on the table for
investors in bonds.
Entering 2022, bonds offered what managers
laughingly referred to as return-free risk-
a phrase that circulated widely but didn't make
it into any marketing materials. The rational
investor had two choices. They could abandon
their traditional 60% stock/40% bond risk profile
and move more to income-generating equities,
something the Fed seemed to be pushing them to
do. Or they could keep their asset allocation
steady but hunker down on the fixed-income side
in money market funds and wait for value to
return to the bond market. A third option of simply
staying the course, however, was advocated
by several well-respected investment shops.
Bonds still had a place in the portfolio and would
somehow continue to provide ballast, they
argued, even though all evidence suggested bonds
had limited ability to do so.
This stay-the-course counsel was reassuring;
there was no mad rush to sell long bond funds nor
public calls for target-date funds to cut their
8
Morningstar Q2 2023
exposure to them in anticipation of the carnage
to come. Sadly, this comforting message
soon came back to haunt investors, raising an
uncomfortable question: Did fund companies, by
keeping quiet in the presence of obvious
dangers, encourage investors to drive head-on
into a rising interest-rate and inflationary
environment, the one thing for which the past
four decades had not prepared them? Admittedly,
it is difficult to anticipate when or how fast
interest rates might rise or to what degree inflation
might return, but it is hard to argue that most
investment professionals could not have calculated
the miserable risk/reward trade-off they were
encouraging investors to assume by staying
the course in a bond market of such limited upside
and such considerable downside.
These stay-the-course advocates included the
major bond index shops-where managers
could not lower durations within their funds. In
arguing that investors should maintain their
positions, they did not play to investors' greed for
added yield as bond promoters have historically
done, but perhaps they did prey on investors'
lack of experience in rising rate environments. In
that sense, one can argue that they did what
bond-fund marketers have long done-they
downplayed the risks they were exposing investors
to. Bond funds have an ignoble tradition of
highlighting the most attractive aspects of their
offerings while diverting attention from their
dangers. No fund firm promotes low-credit-quality
funds; rather, they tout high-yield funds.
Funds full of Mexican bonds get offered as North
American government funds. Funds chock-full
of exotic derivatives are sold simply as U.S.
government funds, often with American flags or
pictures of the Capitol dome festooned upon
their annual reports.
Did the industry similarly camouflage the risks
in bond index funds as we entered 2022?
These indexes had produced strong results in
recent years in part due to their low costs, but also
because they often took on more interest-rate
risk than increasingly cautious active managers
were doing. Much of their success owed not
to the saintliness of indexing, but to taking the
very risks that would come back to haunt investors
in 2022. One can argue, of course, that fund
providers have no responsibility to caution
investors against the risks of an entire asset class
as captured by an index fund. So long as the
index is properly labeled, the risk of owning it is
in the hands of the buyer, they might claim.
After all, long bonds are credible portfolio building
blocks, they will state, and the industry's
responsibility is to craft good tools, not to ensure
their effective use.
There's some legitimate defense in that posture,
but an earlier generation of fund leaders
opted for a higher road. When asked at an industry
conference about his regrets from the late
1990s tech bubble, Vanguard's John Brennan said
he wished he had closed his firm's large-cap
growth index fund, as he saw expectations rising
beyond any reasonable hope of fulfillment.
Jack Bogle went even further, famously warning
American investors entirely away from foreignstock
exposure, saying that he didn't think the
added political and currency risks were sufficiently
rewarded. Where was that kind of leadership
in the industry in 2022?
The fund industry can do better. Asset
management is a business based on trust, and
that trust was damaged last year. Presenting
bond funds as ballast to a diversified portfolio
and a bond index fund as the preferred way
to maintain that exposure, while historically
defensible, likely inflated investor feelings of safety
at a time that fund firms should have been
sounding alarms. There are times in investing
when active choices are required and just hugging
the index is not the wisest course. In an
investment world where the biggest players now
primarily sell asset-class exposure, rather than
active management, the notion that one
never adjusts one's course may be fund investors'
new vulnerability. It certainly was in 2022. K
Don Phillips is a managing director at Morningstar. He is
a member of the editorial board of Morningstar magazine.
The views expressed here are not necessarily those
of Morningstar.
https://www.morningstar.com/authors/286/don-phillips
Morningstar - Q2 2023

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