So what’s the takeaway? Turns out, for once, the risks may be pretty transparent here: tracking AGG will leave an investor massively over-allocated to U.S. Treasuries and U.S. agencies.
Is that a problem? We think so, for two reasons.
The first has to do with return. With GOVT and MBB yielding 1.42% and 2.00% respectively, the core driver of total return for bonds is pitifully low, especially after we account for inflation.
The second has to do with risk. While the replicating index portfolio is made up of three three sectors – none of which represents more than 50% of the overall portfolio – the returns of the sectors are highly correlated. In other words, they don’t necessarily represent three unique return sources, but share among them a high degree of overlapping risk.
SEE MORE: Rethinking Bond ETFs – Unbundle and Rebuild
Using quantitative techniques, we can back out the implied number of statistically unique factors that are driving returns in the portfolio. As it turns out, 91% of the variance in portfolio returns can be explained by a single factor: risk-free (i.e. Treasury) interest rate risk. The other 9% of variance is explained by credit risk.
For investors looking to diversifying their stock allocation, bonds have historically offered an attractive proposition: lower volatility, a steady source of income, and the potential benefit of offsetting returns from a flight-to-safety in a crisis.
SEE MORE: Alternative ETFs Have a Volatility Problem
Today, the de facto standard for fixed income benchmarks – the Barclay’s U.S. Aggregate Bond Index – offers little real yield and has incredibly low internal diversification. With rates near all-time lows, does it make sense to diversify our stocks with a portfolio where 91% of the risk is driven by long interest rate exposure – a bet that will only pay off if rates go lower?
We think not.