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Fixed-Income Index Funds

MFA is an evidence-based advisor and there is sufficient evidence that index-based investing is one of the best ways to invest... in equities. The case for indexing in  fixed-income is not nearly as compelling, which is why we largely avoid passive managers or index-based approaches when allocating to fixed-income. There are four main reasons that we allocate to fixed-income via active managers:

Tax Efficiency

One of the primary benefits of passive management or index investing is tax-efficiency. In short, fewer trades generally leads to less realized capital gains (resulting in lower tax liability). This low turnover approach works well for equities where appreciation is the major contributor to performance with dividends contributing less. However, interest income is the major contributor to fixed-income returns with appreciation playing a minor role (if any at all). Thus, while low turnover can help equity investors turn short-term gains into long-term gains or allow capital to compound tax-deferred for longer, there is rarely such benefit for fixed-income investors.

Index Construction

The construction of many fixed-income indices can also be problematic. Many indices are capitalization ("cap") weighted. For equity indices, this means that larger companies constitute larger portions of the index. For fixed-income indices, this means that entities with the most debt constitute larger portions of the index. Of course, this is not necessarily desirable and we believe there are much better methodologies to weight portfolios.

Distribution of Security Returns

Related to the above two issues is the attribution of returns. Within equities, a small rolling cohort of stocks is responsible for the majority of returns. There is a downside to not owning everything as returns from a minority of "winners" will more than offset losses from the majority of "losers." Within fixed-income, future returns are more or less known as they generally consist of fixed interest payments (hence the name "fixed-income"). So there is little (if any) benefit to owning everything and there is a downside because defaults will decrease returns. Fixed-income investors should diversify enough while also avoiding the worst borrowers.

Liquidity

Unlike equity markets where shares of nearly every public company trade every day, fixed-income markets are not nearly as liquid. Many fixed-income assets do not even trade on a central exchange, but rather via phone, chat, and even by appointment. On any given day, most municipal bonds do not trade at all and many do not trade for months at a time. Most high yield bonds do not trade every day nor do a large portion of investment grade bonds. Recall that an index fund's objective is to mirror the risk and return of an index, not to maximize performance. Index funds are forced buyers and sellers; if cash comes in they must buy and they must sell if they receive redemption requests. This is not necessarily a problem for equity index funds because equities are fairly liquid. However, what happens if a fixed-income funds needs to sell into a skittish market or buy into ebullient one?

While certain types of fixed-income index funds may be less prone to the above issues (such as Treasury index funds), it is important for investors to understand the differences between equity and fixed-income indices before allocating to fixed-income.