Shortfalls of index investing in the fixed income space
The use of index investing has exploded over the last 5-10 years. Just take a look at the investment portfolios that we help construct and most likely you’ll find the use of indexes for a portion of the equity exposure. Not only can these indexes significantly decrease the embedded costs of a portfolio, they are also a very efficient way to enhance diversification. Most equity indexes are designed to track a specified mix of stocks, whether it be the S&P 500 for large companies, the Russell 1000 for smaller companies, the MSCI EAFE Index for international companies, etc.
We believe that when investing in fixed income, having strong and thoughtful active management to complement index investing is often desired to maximize longer-term results.
However, the use of indexes for the fixed income portion of a portfolio isn’t quite as straightforward. Oftentimes, fixed income indexes are based on the amount of bonds issued by a company. Therefore, the company with the most debt has the largest percentage of the relevant index, which isn’t always what is desired by the investor. Additionally, for tax-free bonds, the market is very fragmented (made up of a large amount of small-to-mid sized bonds), and it is basically impossible to replicate a standard index for these bonds. As such, we believe that when investing in fixed income, having strong and thoughtful active management to complement index investing is often desired to help maximize longer-term results.