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- Many investors look at fixed income as the diversifying sleeve of their portfolio, helping to safeguard capital against losses in more volatile equity positions.
- Traditional fixed income indices are very heavily weighted towards U.S. Treasuries and agency mortgage-backed securities, offering very little internal diversification.
- There are numerous extended sectors now available as ETFs that can improve the internal diversification of a fixed income sleeve.
- We quantify the increase in internal diversification using a measure called effective number of bets.
Many investors tend to spend a significant amount of time evaluating their return generators. They spend countless hours analyzing stocks, sectors, countries, and regions.
Their risk mitigators, on the other hand, tend to be swept aside, largely allocated to a broad passive index like the Barclays U.S. Aggregate Bond Index (“Barclays Aggregate”).
For those not comfortable evaluating fixed income, this may seem prudent. After all, the Barclays Aggregate provides exposure to a large number of fixed income sectors, including: Treasuries, residential mortgage-baked securities, commercial mortgage-backed securities, corporates, agencies, et cetera. Sector diversification, however, is only one dimension over which a fixed income portfolio can be diversified. The Barclays Aggregate also provides diversification across maturity and credit quality dimensions.
One could often do much, much worse than a broadly diversified, passively allocated index. That being said, we believe that this approach does not free an investor from ongoing portfolio management responsibilities.
Consider an example from the equity world: in 1989, a globally diversified, market-capitalization weighted equity portfolio would have had a 37.89% weighting to Japanese equities. At that time, Japanese equities had a Shiller PE of over 90. By comparison, in the tech bubble of the late 1990s, the S&P 500 peaked at a Shiller PE of 44.2.
Just as the market-capitalization weighted scheme for passive equity indices can run into trouble with bubbles, the issuance-weighted scheme for fixed income can run into trouble with significant debtors.
Today, for the Barclays Aggregate, the position of potential concern is debt tied to the U.S. government. U.S. Treasuries and agency mortgage-backed securities currently make up over 65% of the index.
So despite all the potential dimensions upon which a fixed income portfolio could be diversified across, the Barclays Aggregate is actually highly concentrated. One way to measure the internal diversification of this index is via a method popularized by Attillio Meucci called effective number of bets.
Effective number of bets relies upon a statistical technique called principal component analysis. While we won’t go into details here, the basic approach is to evaluate a covariance matrix of the underlying positions to identify the unique dimensions of diversification. Once those dimensions are identified, actual portfolio allocations are analyzed to determine how much exposure the portfolio has to each dimension.
While this is a statistical technique, what we often find is that the results are fairly interpretable. For example, for a portfolio of country equity indices, the primary dimensions often correspond to global beta and geographies.
Running this analysis on the Barclays Aggregate, using ETFs to replicate the underlying sectors (GOVT, MBB, AGZ, VCIT, and CMBS) we calculate an effective number of bets of just 1.10.
We interpret this number as saying that allocating to the Barclays U.S. Aggregate is like placing 1.1 independent bets. What does it mean to make 1/10th of a bet? We can think of it as really making 2 independent bets, but only betting 1/10th of the capital on the 2nd bet.
In other words, despite all the potential for internal diversification, there really is just one core risk (interest rates) under the hood.
The good news is that there are a variety of extended fixed income sectors available as ETFs that can be used to complement a core holding like the Barclays Aggregate.
Below we plot a table where we shrink all of the sector weights of the Barclays Aggregate by 10%, and redeploy this 10% into an extended sector. We then re-compute the effective number of bets.
Effective # of Bets
International Sovereign Debt
International Corporate Bonds
International High Yield Bonds
High Yield Bonds
Emerging Market Debt (USD)
Emerging Market Debt (Local Currency)
High Yield Municipal Bonds
We can see that something as simple as adding a 10% slice to just one of these extended sectors can dramatically increase the effective number of bets.
Fixed income has played a historically important role as a ballast of risk. Today, however, the heavy concentration of the Barclays Aggregate in a few highly correlated sectors reduces the internal diversification available and makes portfolio results highly dependent on just a single factor. Thoughtful incorporation of extended fixed income sectors may help ensure that your main portfolio diversification doesn’t have its own risk concentration problem.
John Bogle famously said of market-capitalization weighted investing, “Don’t look for the needle in the haystack. Just buy the haystack!” While we do not necessarily disagree with the sentiment, we do believe that investors should know what’s in the haystack. Nowhere is this more important today than in the fixed income universe.