The Independent Adviser for Vanguard Investors
•
July 2014
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5
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After more than 30 years of declining interest rates, most inves-
tors have little experience with a real bear market in bonds. How
would you define a bond bear market?
If you had a significant rise in rates in a short period of time—so a
couple hundred basis points, say 200 or 300 basis points. A back-up of
100 basis points—which we’ve seen over the course of the last year—
that’s not a bear market.
When I think about the people investing in bonds, the question is,
”Why are they investing in bonds?” Part of it is for income, and part of it
is for diversification and capital stability. Ultimately, if you are matching
up your risk tolerance and time horizon with the right type of bond prod-
uct, rising rates aren’t necessarily a bad thing.
Say you have a long time horizon, and you are invested in either a
short-term or an intermediate-term bond fund. The fact that you are going
to have coupon and principal that gets reinvested at higher rates is actu-
ally a better thing for you than if rates were to stay the same or go lower.
The worst-case scenario would be someone who has a very short-term
time horizon and is invested in a very long-term product that is very sen-
sitive to changes in interest rates.
Going back to defining a bond bear market, you said a rise in
rates over a short period. What’s a short period?
If you saw that [200 to 300 basis point increase] happen in the course
of a year or two, that could be viewed by the broader market as pretty
negative. The question becomes, what would be a catalyst for something
like that happening? One, the economy is clearly growing faster than
expected or inflation is picking up more than what’s been expected by
the marketplace…or a combination of those two things. The market
would then be potentially thinking, “Hey, the Federal Reserve is behind
the curve and will need to play catch up,” and there’d be a pretty rapid
adjustment in terms of where Fed policy is going to be.
For individual investors and for professional investors, it can be very
difficult to pick those exact points when you get a transition into a rising
rate environment or a declining rate environment. If you are investing in
bonds because you are chasing the returns that you’ve received over the
last 10 years or so, that’s not the right reason, because those returns are
very unlikely to be met over the next five or 10 years, given where we are
starting with today’s yields.
So, reinvestment is the silver lining that investors can take from
rising rates.
Investors don’t appreciate that fact. Right? Whether or not you own
individual bonds or a fund, as those bonds get closer to maturity and
get reinvested at higher yields—people forget about the benefit you are
going to get from that.
We write about that quite often.
It just doesn’t sink in for a lot of investors. And the other key piece, I
would say, when you think about the argument that, “Hey, rates are ris-
ing, I should sell out of bonds and go into money markets or something
else,” you know, the reality is the slope of the yield curve tells you the
market’s already pricing in rates rising. So it’s not enough to say that
rates are going to rise. The question is, are rates going to rise more
than what’s already priced in? That’s really what your breakeven is in
the rationale given in a web-based mis-
sive, “Adding Value Through Multiple
Investment Managers,” posted concur-
rently with the Explorer announcement.
The value-adds that Vanguard cites
include broader diversification, which I
would call “diworsification.” Also, they
say that by focusing on their best ideas,
managers will both reduce volatility and
won’t have to worry about focusing on
their benchmark. It is true that the kind
of broad diworsification that exists at
Explorer has slightly reduced risk, at
times. In the chart above, you’ll see that,
based on 24-month relative volatility at
the end of each year, Explorer used to be
slightly riskier than
SmallCap Growth
Index
, and has over time become less
so. But in 2013, for instance, the index
fund’s two-year volatility was higher. So
where’s the consistency?
Also, the notion that diversification
will allow managers to worry less about
their benchmarks begs the question of
whether other Vanguard managers at
less-diversified funds are indeed “wor-
ried” about their benchmarks. Shouldn’t
they simply be worried about follow-
ing the investment process Vanguard
hired them for in the first place? Active
managers aren’t supposed to be paid to
be closet indexers, so what’s the point
of saying they’ll be less worried about
their benchmarks?
Vanguard also says that in choosing
multiple managers they look for perfor-
mance histories that don’t overlap. In
other words, they don’t want all the man-
agers earning excess returns at the same
time. That might work with two manag-
ers, or maybe even three. But eight?
In fact, if you take their comment
that they are seeking little or no over-
lap to its logical extreme, then that
would suggest that every eight months,
one manager is outperforming while
the other seven are underperforming.
Weird, and not particularly productive.
“What we’re really doing,” Vanguard
says, “is what thoughtful investors
should always do. We try to find
Explorer vs. Russell 2500
Growth Index
3/04
3/05
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3/14
rising line
= Explorer outperforms
0.85
0.90
0.95
1.00
1.05
-Manager hiring
-Manager firing
Relative Risk
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
1998
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Explorer
SmallCap Growth Index
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