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FAQs

Why does Dimensional offer a global fixed income strategy but no international-only fixed income strategy?

FAQs

Why doesn't Dimensional offer portfolios investing in mortgage-backed securities, convertible bonds, or high yield debt?

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Update of the Research Underlying Dimensional's Bond Strategies

Many investors and financial commentators believe high earnings growth rates and high rates of return go hand in hand. But earnings growth only determines the breakdown of total returns into dividend yield and capital gain. Total expected returns are determined by risk alone.

Fixed Income

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Dimensional approaches fixed income primarily as a strategy to maximize overall portfolio benefit. Shorter-term, higher-quality debt instruments tend to have less risk. Dimensional engineers lower-risk bond strategies so investors can temper their total portfolio volatility or take more risk in equities, where expected returns are greater.

The Maturity Decision

Most investors recognize that short-term fixed income strategies are less volatile than long-term bond strategies. The difference in standard deviations between short-term securities like Treasury bills and long-term securities like twenty-year Treasury bonds is startling. In fact, long bonds have volatilities approximately five times that of the one-year Treasury bill.

In addition, short-term bonds have a lower correlation with equity portfolios than do long-term bonds. If risk reduction is the primary goal, the evidence is strong that short-term is far more effective than long-term fixed income.

Perhaps less apparent to investors, historical data shows there has not been a reliable return premium for extending maturities into longer bonds.

Quarterly: 1964-2005.

One-Month Treasury Bills, Five-Year Treasury Notes, and Twenty-Year Government Bonds courtesy of Ibbotson Associates. Six-Month Treasury Bills courtesy of CRSP (1964-1977) and Merrill Lynch (1978-present). One-Year Treasury Notes courtesy of CRSP (1964-May 1991) and Merrill Lynch (June 1991-present).

One reason this result may be surprising to many is that recent history does not conform to this long-term result. The data from the period 1982 through 1993 shows a tremendous premium for maturity extensions. In this period, long-term bond returns were more than double the returns of short-term bonds and almost kept pace with the return of the stock market. Yet a longer perspective would indicate this outcome was more the exception than the norm.

Bond Market Efficiency

With no reliable "term premium," investors could only hope for astute active management in order to extract value out of long-term bonds. Managers possessing the ability to forecast interest rates stand to profit more from their approach by using long bonds when their forecast calls for declining interest rates. But can managers reliably forecast interest rates? Many studies have been done regarding the question of bond market efficiency, research similar in nature to efficient market studies performed on the stock market. The conclusions are similar—there is no reliable method of forecasting future bond prices and therefore future interest rates.

If we accept that the bond market is efficient, the returns of active bond portfolios should mirror the results found in active stock portfolios—an inability to consistently outperform their benchmarks. Indeed, this was the outcome found in research conducted by Blake, Elton, and Gruber.¹ The researchers found that when properly categorized, bond funds underperformed relevant indexes. The amount of this underperformance was approximately equal to the fund expenses. Gross of fees, bond funds on average perform on par with their appropriate index.

Dimensional's Variable Maturity Strategy

Investors seeking short-term, interest-rate-neutral portfolios are not limited to "buy and hold" or indexing strategies. These approaches fail to capture changing opportunities offered by a changing yield curve environment. Trades that reduce volatility and increase yield may have no inherent appeal in an index approach even though they may be very attractive to the diversified investment portfolio. Buy and hold strategies, such as a laddered approach, are equally indifferent to a changing opportunity set.

Investors may be able to increase their risk-adjusted returns with an alternative approach developed by Professor Eugene Fama of the University of Chicago. This variable maturity strategy shifts the maturities of the portfolio as yield curve changes create the possibility for lower-risk, higher expected return outcomes. In recognizing the bond market as being highly efficient, the variable maturity approach does not anticipate changes in the yield curve; rather, it seeks to maximize the risk-adjusted returns present in the current curve. The variable approach would shorten from five-year maturities to two-year maturities in the example above. In an efficient market, the best estimate of future bond prices or yields is simply today's price or yield. New information is unpredictable. Fama's research showed that the best estimate of future yield curves is simply today's yield curve. It is not a statement that the curve will not change, but a statement that the changes are unpredictable. The objective of the strategy is then to take what is offered by the current curve. In broad terms, this means shortening maturities in inverted curves, and extending in upwardly sloped curves.

Determining the Optimal Maturities

The Shape of the Yield Curve

Hypothetical yield curves of a fictional fixed income product, presented solely as an example.

The above figure graphically depicts the effect of different yield curve shapes on optimal maturity selection. However, it describes only one aspect of the variable maturity strategy. Even without forecasting changes in today's yield curve, there exist a myriad of potential strategies, each with a unique expected return. Dimensional offers four US strategies with differing maturity parameters: the One-Year Fixed Income Portfolio, the Five-Year Government Portfolio, for investors seeking income free from federal income tax, the Short-Term Municipal Bond Portfolio, and for investors seeking income that is expected to be free from both federal and California state personal income tax, the California Short-Term Municipal Bond Portfolio.

Dimensional also offers two US strategies that invest in fixed income securities within certain maturity ranges: the Intermediate Government Fixed Income Portfolio and Inflation-Protected Securities Portfolio.

The figure below shows a sample matrix of expected returns generated for varying initial maturity choices and holding periods. For each expected return, a horizon analysis is conducted. In each case, the analysis depends on three factors: the purchase price of the bond, the yield or income generated over the holding period, and the sale price of the bond. To calculate, for example, the expected return for the strategy of buying a two-year bond and holding for six months, we start with the purchase price of two-year bonds. This is observed in today's marketplace. This price will determine a yield that will be earned over the six-month holding period. The unknown factor is the sale price of the bond six months hence. To generate an expected return, an expected price or yield is needed for what will be an eighteen-month bond, six months from now. Using the Fama research, we use today's curve as our estimate of the curve six months from now. We use today's price or yield of eighteen-month bonds to estimate the price or yield of eighteen-month bonds six months hence.

Finding the Optimal Maturity and Holding Period

Hypothetical yield table of a fictional fixed income product, presented solely as an example.

In general, yield is a poor estimate of expected return. In upwardly sloped curves, expected returns are generally higher for strategies that do not hold bonds to maturity. The variable maturity approach will highlight the optimal combination of initial maturity and holding period—in essence, the best segment of the curve to hold. This combination will change as the shape of the curve changes. In each case, though, the strategy seeks to make optimal use of information embedded in today's efficiently priced yield curve.

The Use of Global Bonds

Generally, investors pursue global portfolios in order to diversify. Statistically, diversification should result in lower portfolio volatility due to the combination of uncorrelated assets. The use of non-dollar developed market bonds, however, introduces foreign currency exposure. Currency exposure may increase the volatility of a fixed income portfolio.

Introducing foreign bonds into a domestic portfolio may reduce the volatility of the portfolio. Dimensional offers portfolios of hedged global bonds, including the Two-Year Global Fixed Income Portfolio and Five-Year Global Fixed Income Portfolio. These global portfolios take advantage of imperfect correlations among developed bond markets and enjoy the classic benefits of diversification. Further, given the global nature of highly rated debt issuers, this international diversification can be reached without sacrificing the credit standards maintained in domestic portfolios.

In terms of returns, just as investors are no longer subject to the risk of one bond market, they are no longer subject to the expected returns of just one yield curve. Expected returns across global bonds differ as the shape of each yield curve is different. Portfolios can be formed that are tilted toward the higher expected return countries. In this case, portfolio maturities and country weightings follow a variable approach based on the expected return matrix generated for each eligible country.

In our view, global bonds do not represent a separate and distinct asset class from domestic fixed income. Instead, the use of currency-hedged and unhedged, non-dollar bonds along with domestic bonds allows investors to create a more diversified, less risky fixed income and overall investment portfolio.

For investors willing to accept some currency volatility in the fixed-income portion of their portfolio in pursuit of higher returns, Dimensional offers the Selectively Hedged Global Fixed Income Portfolio. Depending on an investor's risk tolerance and asset allocation, introducing additional currency exposure may do little to alter the volatility of the overall portfolio.

PRINCIPAL RISKS (fixed income)
The principal risks of investing in these portfolios may include any of the following: market risk, foreign securities and currencies risk, interest rate risk, inflation-protected securities interest rate risk, credit risk, risk of banking concentration, risk of investing for inflation protection, income risk, call risk, tax liability risk, state-specific risk, and non-diversification risk. These risks are fully described in the prospectus in the section entitled "Principal Risks."

  ¹ Christopher R. Blake, Edwin J. Elton, and Martin J. Gruber, "The Performance of Bond Mutual Funds." Journal of Business 56.3 (1993): 371-403.