When does indexing investments require caution?

I’m a big fan of index funds. I prefer lower-cost asset class funds (similar to indexes, but more surgically structured to target factors or asset classes), but let’s not nitpick here. Today, the investment world well knows the value of indexing.

Index funds are generally mutual funds or exchange traded funds constructed to match the components of a market index such as the S&P 500, EAFE, or Aggregate Bond Market (among literally dozens if not hundreds more).

Index funds are generally very low cost, relatively tax efficient, fully transparent, easy to understand, and easy to allocate among portfolio holdings, including diversification.

Index funds, generally by design, over-weight the most “valuable” or “largest” companies. This can be good because the most valuable companies can sometimes be the best performers, as well (it’s a circular reference).

This can also be a time for caution because in bond indexes, for example, the most indebted nations or companies can make up the largest allocation in the index.

Today, that’s where some index funds have gotten concerning. Case in point: international bond index funds.

International bond investing has strong supportive evidence of diversification benefits, but if you haven’t read the financial news of late you might be surprised to know that — today — many foreign developed countries are actually paying “negative” interest rates. In other words, investors are paying to hold money! Yes, you read that correctly.

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So if you buy an international bond index fund that simply market-weights foreign country debt, including those paying negative rates, you will find a very unappealing return for duration exposure. (Duration is the blended term weight of all the bonds).

For example, Vanguard’s Total International Bond Index currently has a 0.63% 30-day SEC yield (according to Morningstar) with a duration of 7.63 years! Assuming 30-day reflects forward yield (which is debatable and beyond the point of this article), this means if that portfolio rate even rises one-tenth of 1% in this scenario, you wipe out a full year of yield!

Again, indexing can be great. We’re big fans of it, but sometimes markets get super bizarre and defy sensible positioning. My blog posts aren’t meant to be specific advice driven pieces for obvious reasons; rather, this article is a reminder that whether it’s a bond index or something else you own, don’t simply blindly adhere to it without looking under the hood every once in a while to make sure you appreciate the scope of the investment.

MICHAEL DUBIS is a fee-only CERTIFIED FINANCIAL PLANNER™ and president of Michael A. Dubis Financial Planning, LLC. He also previously served as part-time lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.

Disclaimers: This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s.

Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio's performance are based on historical data and one should not assume that this performance will continue in the future.

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