Vanguard: We’re not troubled by duration in Lifestrategy

Vanguard has faced criticism for soaring duration in its fixed allocation Lifestrategy range, but investment strategist Ankul Daga is doubtful tactical decisions made by active managers will deliver superior results.

Investors often worry about their bond holdings when interest rates rise. Typically, the longer the maturity of the bond, the higher its duration is, making it more sensitive to changes in interest rates.

As funds with a fixed asset allocation, Vanguard’s Lifestrategy range has exposure to both long- and short-duration bonds. The duration of the fixed income portfolio of the four funds that allocate to fixed income averages between 9.1 and 9.3 years. This means that when yields go up by 1%, the bond portion of the Lifestrategy fund would go down by around 9.1 to 9.3%.

When we think about bonds, is it wise to focus only on interest rates? Short-term policy rates alone do not determine longer-term bond yields. Long-term yields are driven by market expectations of future interest rates, term premium and demand and supply in the market. The bond market is heavily researched and valuations are reassessed constantly. What this means is that the most important factor in whether bond prices go up or down is not just the level of yields, but to what extent this was priced in (or expected) by the market.

As central banks raise interest rates and withdraw quantitative easing, how likely is a surprise? Currently the question isn’t whether bond yields will go up or down, but rather how fast they will go up. Through their forward expectations, central banks have sent clear signals that increases in interest rates are likely to be gradual and peak at a level lower than previous cycles. Based on balance sheet projections, the pace of withdrawal of QE is expected to be reasonably stable. Global bond markets are highly interconnected. As an example, the Lifestrategy 60% Equity Fund invests in bonds from 58 countries. While policy normalisation is beginning in the US, QE continues in the euro area and Japan.

But what if there is a shock to the market? What if yields do rise more quickly than anticipated? Are tactical managers best placed to succeed over funds like the Lifestrategy range? To benefit from a market shock, a tactical manager has to predict market movements (in particular yields) with a high degree of accuracy.

Research shows that it’s extremely difficult for active managers to beat the market. Most active managers have a poor record of success, especially once higher relative costs are taken into account. The market has expected yields to rise since 2011, with warnings of a bond bear market for a number of years, but the long-feared bond Armageddon has not materialised. In fact, while yields have been stable, investors in longer duration bonds have collected a higher level of income.

With such headlines, one might forget the benefits of bonds. High-quality fixed income serves a dual purpose in a portfolio. Firstly, it reduces risk at a portfolio level. Secondly, it’s a source of stable income. So, should investors hold short-duration bonds? Short-term bonds may be less sensitive to interest rate rises but they offer reduced protection during equity market corrections and provide less income.

When comparing the risk-mitigating benefits of bonds, we should consider not only volatility, which measures short-term risk, but also drawdowns, which capture long-term risk. The chart below shows the performance of a range of bonds during a strong equity drawdown.

Median quarterly return of high-quality global bonds (hedged into sterling) during the worst quartile of global equity performance Jan 1999 – Feb 2018

Source: Vanguard calculations, using data from Barclays Live as at 28 February 2018.

The chart above shows that long-duration bonds offer better protection to a multi-asset portfolio when it needs it the most.

Tactical strategies may promise higher returns but research shows that most fail to succeed after costs. Lifestrategy offers investors broad access to the market to help them reach their long-term goals through a set of enduring investment best practices.


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