Since I am expanding my portfolio to beyond just IRAs and 401ks, I will need to move my more tax-inefficient investments like bonds into those tax-deferred accounts. This way, I’ll put more of my stocks in a plain taxable account which is taxed at the more favorable long-term capital gains rates.
Fidelity is my Solo 401k provider, so I was looking through their bond offerings. Their only bond index funds are the Fidelity U.S. Bond Index Fund (FBIDX) and essentially a US Treasury bond index fund with different maturity lengths. Looking at FBIDX, its benchmark is the Barclays Capital U.S. Aggregate Bond Index. This index covers the all US bonds on the market that are investment grade and taxable, including Treasuries, corporate bonds, and mortgage-backed and asset-backed securities.
This is basically the same benchmark index as the Vanguard Total Bond Market Index fund (VBMFX), which follows the Barclays Capital U.S. Aggregate Float Adjusted Bond Index. (ETF version is ticker BND.) The “float-adjusted” part just accounts for all those Fannie Mae bonds that are now owned by the government and thus not actually available on the market anymore. They should be the same, right? Nope.
A perk of being a financial blogger is companies give you free stuff to try, and Morningstar offered me a free 1-year subscription to their paid Morningstar Premium service which offers stock and mutual fund research. Being a mostly a low-cost index fund investor, most of their content didn’t really interest me. However, I started reading the FBIDX Analyst Report and was surprised. The teaser line was:
Although this fund is designed to track the Barclays Capital U.S. Aggregate Bond Index, it lagged that bogy by more than 3 percentage points from mid-2007 through the end of 2008.
Lagging a benchmark by 3 full percentage points is a lot in the index world. Passive investors want low costs and low tracking error from the target benchmark! That’s how we get our greater-than-average return over the long run. It turns out that Fidelity had been making “modest” bets outside of the index in order to juice their returns, including minor exposure to subprime mortgages through an “ultra-short” bond portfolio*. FBIDX costs more than VBMFX by about 0.12% a year, so they would always lag if all other things were equal, and needed to take such additional risks in order to have better performance numbers.
The report goes on to report that the fund hired a new manager in February 2009, who says he’ll run a tighter ship:
Since joining the fund in February 2009, he [lead manager Curt Hollingsworth] has taken steps to ensure that it will closely track its benchmark from month to month. He thinks actively run internal bond portfolios have no place in this passively run offering, which should reduce the chance of things going awry. He also pared the fund’s exposure to out-of-index bonds from 8% to just 2% of assets lately.
Well, that’s nice to hear, but too late for me. When I see “index” in the fund name, I expect it to match the benchmark, not try to beat it like everyone else. Thus, I’m most likely going to construct my portfolio out of Vanguard bond ETFs instead. My transaction size should be great enough to counteract the hit from each individual stock trade. (Read about the Vanguard ETF vs. mutual fund cost comparison tool.)
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It’s also worth noting that the index these funds track is HUGE and it is hard to guarantee the bonds purchased will exactly match the index hence the variability between Fidelity and Vanguard.
Not saying this is what happens for sure, but the Vanguard fund holds over 3000 bonds while the Fidelity one just under 1000. This could account for some of the difference.
thanks for the heads up… I hadn’t realized that FBIDX had that kind of tracking error. a few years ago, I was lucky enough to be on a 401k committee at my small company. I pushed hard to make sure a few index funds were included, and succeeded in getting 3 Vanguard index funds (total stock, total international, & total bond). things were fine for about 1 year, until the plan provider pulled the ol’ switch-a-roo, claiming since everything was run through Fidelity, we had to use more of their funds, and changed our 3 index funds from Vanguard to Fidelity. I still use them, as they are my best options in the plan, but I will pay more attention to them and how they track their respective index.
thanks, my2fish
So where’s a good place for those of us who don’t want to pay $200/year for Morningstar to find out that our bond funds may not be matching their index?
Or should we all just start a finance blog? 🙂
Steve: Just buy Vanguard.
@Matthew – Agreed, the index is huge which is why all the funds use statistical sampling to make up their funds. “Indexing skill” does exist, and Vanguard has been doing it the longest.
Still, the 3-year annualized return for VBMFX is 6.58% and FBDIX is 5.71%. That’s a really big difference for two funds tracking the same index. This period includes the subprime crisis, but their long-term numbers are more similar.
@my2fish – I suspect that FBIDX will still do comparatively well in the near future, especially after this recent fiasco. But I just see this as a systemic issue, once people forget over time, they’ll start “enhancing” returns again.
@Steve – To a certain extent, I would do like Chuck said and buy Vanguard, the fact that they offer bond ETFs makes it much easier. But other than that, you can compare their performance directly to the benchmark for free with the performance charts on Morningstar.com. You can also compare with other index funds by Vanguard which traditionally have very small tracking error.
For slight variations, its good to tweak the date range so that you can look closer at dates like from 2008-2010 when there was so much volatility.
Way ahead of you both on the whole “buy Vanguard” thing and they do have my trust. However, as was famously said “trust but verify”…
There’s also the small matter of 401(k)s where I don’t necessarily have the option of buying Vanguard.
Thankfully, Morningstar provides the Modern Portfolio Statistics in the fund “Ratings and Risk” section. Somewhat unusually, they actually tell us what the “reference” statistic is– in the case of both FBIDX and VBMFX it’s the “BarCap US Agg Bond TR”.
FBIDX: r-squared is 97, VBMFX is 99. Perfect tracking would be 100
FBIDX: beta is 0.91, VBMFX is 1.00. Perfect tracking would be 1.00
FBIDX: alpha is -0.48, VBMFX is -0.08. Perfect tracking would be 0.00
Especially for bond funds where ostensibly each fund is buying the same (or at least VERY similar) underlying bonds, tracking the stated index is critical. That FBIDX is off should be disconcerting…
(Beta is the slope of a least-squares regression line plotted against the reference. Alpha is the y-intercept of the same line.)
This only works if the “reference” is the index being tracked, otherwise the numbers are at best meaningless and at worst misleading…
@sbonds – Excellent tip, I didn’t know M* offered such data.
So what are you going to buy in your Fidelity Solo 401(k)? I assume you cant buy Vanguard ETFs in there. I also have a small Fidelity Solo 401(k) due to the lack of account fees but the high minimums most funds require to avoid maintainance fees make choosing a fund difficult.
thanks
We’ve got Fidelity @ our 401k too…but we’re moving shortly.
My experience with Fidelity Bond Funds (FSHBX – Short Term & FINPX – TIPS) left a bad experience in my mouth.
FSHBX was invested in Currency Swaps, CDO’s and CDS’s…some of the stuff that blew up in the fall of ’08. Then, after they sold the stuff off, the managers went heavily into cash, almost 20% for several months.
Comparison chart between FSHBX and VBISX (Vanguard ST Bond)
http://finance.yahoo.com/echarts?s=FSHBX#chart6:symbol=fshbx;range=2y;compare=vbisx;charttype=line;crosshair=cross;ohlcvalues=0;logscale=on;source=undefined
FINPX was invested in Sub-Prime Mortgage Securities. Why a TIPS fund would do that I have no idea…
http://www.bloomberg.com/apps/news?pid=20670001&sid=aBg9QZluwYDQ
Check those quarterly and/or monthly holdings!
Vanguard invented the cheap-and-simple model while all the others were dragged into it kicking and screaming only because of the competition. Buy Vanguard whenever possible and transfer other funds to Vanguard when the transaction costs make sense. I’ve used some State Street funds out of convenience, but will be phasing them out too. However, their S&P 500 mutual fund (SVSPX) is quite cheap so its hardly worth the effort to change.
Also, as far as fund information goes, don’t miss free sources of data. There’s quite a lot for free at Morningstar, plus Yahoo finance, Google finance, etc. Many brokerages have free research data available too (e.g., Scottrade has fairly decent info). Ignore the research of those that sell their own funds.
Amusingly, if you look at the 10-year chart on Morningstar between Fidelity and Vanguard bond funds (FBIDX vs VBMFX) you’ll see that Vanguard screwed up similarly in 2002, and Fidelity screwed up in 2008. The 10-year results are $18,276 for Fidelity, and $18,240 for Vanguard. So Fidelity is not exactly the villain, here. Of course that means Vanguard learned their lesson 6 years before Fidelity did. 🙂
Or perhaps they changed from one index (Lehman Aggregate Bond Index) to another (Barclay’s US Aggregate Bond Index) making any back-comparison to the current index invalid.
Perhaps. 🙂
@Myles – Yes, you can buy most exchange traded stocks or ETFs in the Fidelity Solo 401k (not necessarily employer-sponsored 401k). Your commission ranges from $8 to $20 depending on your total Fidelity balance.
@over the cubicle wall
Is that even an index fund? Different league.
I went with PIMCO’s PTTDX for my bond fund.
Jonathan, as others have said, thanks for the heads up. Just dawns on me… Of course, we raise a red flag if an index fund fails to achieve its benchmark return. However, if an index fund *beats* their benchmark it should also be considered a bad sign… shows they are deviating from the benchmark and got lucky… that’s not what we,as index fund investors, wanted. Next year they probably will not be as lucky.
Steve, I don’t think the “change” in index was related to anything other than Lehman ceasing to exist recently, and thus their indices being renamed / changing hands.
Chuck’s post above rings true for me, as I do recall having read about a fumble Vanguard made with its Total Bond Market fund somewhere around 2002. Not sure of the details, however.
Thanks so much for bringing up this important point with Fidelity (and pretty much most of the non-Vanguard brokerages and their bond fund offerings.) I will follow your advice!
Jonathan,
You make a good point in opting for the ETF. It appears you have the discipline to “stay put”, so transaction costs shouldn’t be a factor.
As for the new “Manager”; they often have something to “prove” to upper management and will tend to be too active (If you look at most Bond Funds including PIMCQ, you’ll see an enormous turnover rate); it’s common to see turnovers of 100%-300%! And just of the transaction costs passed down to the investor!
Will you be taking advantage of the Roth IRA for the “BEST” tax treatment?
OK, so I clicked the box in the upper right corner which opened a window displaying account breakdowns, one of which is a Roth IRA, so please disregard my final question in my comment 🙂
Individuals are sometimes better off buying individual bonds. If you are the kind who is tempted to get scared when you see the bond fund drop in price when you didn’t realize they could (because interest rates went up), then you may want to buy individual bonds (laddered by different maturity dates) and hold them to maturity.