How could a bond fund this bad get to be so big?
Vanguard Total Bond Market Index Fund (ticker: VBTLX) is the world's largest bond fund, with $209.5 billion under management as of February 28, 2019. Mutual funds and exchange-traded funds (ETFs) typically attract investors based on their performance; however, VBTLX is the anomaly, as it has grown in spite of poor VBTLX performance.
We attribute much of this growth to the constant drumbeat from financial advisors, investment gurus, and the media to invest in 'low-cost' mutual funds, as investors (i) shouldn't expect to beat 'the market' and (ii) the one thing investors can control is cost. When a bond fund averages a 1.63% return for 2015-2018, as VBTLX did, investors should ask themselves whether these so-called experts know what they are talking about.
We strongly believe they do not.
The Building of the Investing Road to Nowhere
While investing directly (i.e., without a financial advisor) in VBTLX leads to poor returns and missed investment opportunities, an even worse investor outcome is when financial advisors place clients into underperforming bond index funds such as VBTLX, as illustrated in Figure 1 below. Vanguard Total Bond Market Index Fund is split into a number of share classes, of which, the Admiral Shares class (VBTLX) is the largest, with $90.7 billion in net assets on February 28, 2019. Performance is similar across all of the fund's share classes, but when we refer to VBTLX performance, it will be for the Admiral Shares class.
Financial advisors typically charge clients 1% of a client's investments to oversee an investment portfolio. This expense could be warranted if an investor achieved compelling returns as the result of an advisor's recommendations. Unfortunately, when VBTLX averages a 1.63% return over a four-year period, the advisor makes out like a bandit while the investor is left with scraps.
In Figure 1, the blue bars show the VBTLX returns, and the orange bars represent the 1% annual financial advisor fee. The gray line is the investor's return after paying the advisor his 1% financial advisory fee.
Figure 1: VBTLX Performance with Financial Advisor Fee Impact
Over this four-year period, the average annual VBTLX return was an anemic 1.63%, lower than inflation. After the annual 1% financial advisor fee, however, it's an even-lower 0.63%, as the advisor's fee is higher than the all-in investor return.
Figure 2 shows a hypothetical $100,000 investment, where, on behalf of a client, a financial advisor invested into VBTLX from January 1, 2015 through December 31, 2018. The gray bars show what the investor earned after paying the financial advisor her 1% annual advisory fee.
Figure 2: Investor Returns for $100,000 Investment in VBTLX
As shown in Figure 2, the advisor and Vanguard make money regardless of how the investor performs even though it's the investor who is taking all of the investment risk. This is a sweetheart deal for the advisor but a raw deal for the investor, as, over this four-year period, the advisor made $1,531 more than his investor client, as shown in Figure 2 and summarized in the Figure 3 scoreboard.
Figure 3: 2015-18 Financial Advisor Fees vs. VBTLX Returns to Investors
When a financial advisor makes substantially more money than his client, it should call into question the rationale for this financial-advisor-to-Vanguard investment vehicle. In addition, when the investor return, after all fees, averages 0.63%, we scratch our heads as to how a bond fund as bad as VBTLX has attracted so much investment.
It's why we call it the "Vanguard Bond Fund Road to Nowhere."
How did we get here?
Financial advisors have a difficult task. They have to grow their book of business, service client relationships, and ensure a client's investment portfolio remains on track. These investment portfolios contain many types of investments, many of which, especially bonds, financial advisors may lack sufficient knowledge. In addition, if a financial advisor has 100 clients, he simply doesn't have the time to select individual bonds for a client portfolio. As a result, about 99% of financial advisors outsource fixed income investments to large asset managers such as Vanguard.
While this might have worked up until a point, when hundreds of thousands of investors pour money into the same fund, investment discretion goes out
the window. Instead, large fixed income mutual funds such as VBTLX invest in large blocks of bonds they can rapidly turn over to satisfy investor
inflows and outflows and to put hundreds of billions of dollars to work. This focus on quantity over quality has hurt VBTLX performance.
Drivers of poor VBTLX performance
Our recent fixed income blog post discussed how high portfolio turnover of bond funds creates significant hidden costs. We show how bond fund expense ratios exclude transaction costs, which significantly understates the true cost of bond funds. While this is a significant factor driving weak bond fund investment returns, this post's focus is on another key driver of bond fund returns: portfolio composition.
Suppose an investor would like to invest $100,000 in the US fixed income market. As our founder Steve Shaw discussed in his July 16, 2018 SEC presentation on retail investor corporate bond prices, individual investors can take advantage of a competitive marketplace for individual corporate bonds where the bid-ask spreads are often comparable to those enjoyed by institutional investors such as Vanguard and BlackRock. Investors can create a select portfolio of corporate bonds that reflects their risk tolerance and returns objectives. We have shown how the corporate bond returns of BondSavvy's recommendations can exceed investment returns offered by leading ETFs such as the iShares bond ETFs.
It's a much different story when that same $100,000 investment is pooled with hundreds of thousands of other investors in the $209.5 billion Vanguard Total Bond Market Index Fund. While Vanguard has done much good for investors, it is very difficult to drive compelling returns when investing over $200 billion in fixed income securities. The fund held 8,462 bonds as of February 28, 2019, and there simply are not thousands of bonds worth owning. Such a large portfolio dampens VBTLX performance by requiring Vanguard to break key investment rules by 1) buying bonds regardless of their price and 2) concentrating investments in securities that are big but often lack compelling returns.
VBTLX's 13-largest holdings are mortgage-backed securities issued by the likes of Fannie Mae (aka 'Federal National Mortgage Association'), Freddie Mac (Federal Home Loan Mortgage Corp.), and Ginnie Mae (Government National Mortgage Association), all of which were put under federal conservatorship in September 2008. Other large holdings are US Treasury notes and bonds. You'll see many of these holdings total billions of dollars for one group of securities. When it comes to VBTLX investments, size certainly does matter.
Figure 4: Top-20 VBTLX Holdings as of February 28, 2019 (1)
(1) Source: Vanguard
While the US Treasury holdings indicate a coupon and a maturity date and are reasonably straightforward, the mortgage-backed securities are opaque at best. Each line item shows an issuer, a coupon, and then a range of maturity dates, as each row contains a pool of different securities. Fixed income investors looking at this table would be hard pressed to understand exactly what they are buying given the weak disclosures and investors' general lack of familiarity with the complexities of mortgage-backed securities. In our view, individual investors have no business owning securities they do not understand such as mortgage-backed securities.
Figure 5 aggregates the holdings of all of the securities held by VBTLX, showing the concentrations in mortgage-backed securities (24.3% of total portfolio) and Treasurys (43.4%). Corporate bonds represent a smaller portion of the portfolio (26.4%), as corporate bonds cannot be bought and sold in the large quantities in which funds transact mortgage-backed securities and Treasurys.
As we said before, the VBTLX investment thesis is quantity over quality.
Figure 5: Vanguard Total Bond Market Index Fund Portfolio Holdings (2)
(2) As of February 28, 2019. Source: Vanguard
Regardless of whether a person uses a financial advisor or not, investments into VBTLX have been a 'Road to Nowhere' for hundreds of thousands of investors. VBTLX performance is not compelling, and nearly 25% of the fund is in mortgage-backed securities -- opaque investments not understood by the vast majority of investors. In addition, the fund is highly sensitive to interest rates given the concentration of Treasurys and mortgage-backed securities. Read our blog post on how to profit from rising interest rates.
While this Vanguard bond fund on its own is a clunker, investors compound the problem when they invest through a financial advisor who, in turn, places them into VBTLX. A one-percent advisory fee is a lot of money, especially when money is being invested in VBTLX, which has returned 1.63% from 2015-18 and the advisory fee eats up a majority of the VBTLX returns.
Investors seeking a road to a better place can invest in individual corporate bonds, where they can enjoy many advantages over bond funds, including higher potential returns, lower fees, and greater investment transparency.