The WSJ’s monthly section on investing in funds ran a generally informative piece on the new bond exchange trading funds. It pointed out that the new bond etfs aren’t necessarily better than existing bond index funds like those of Vanguard in terms of fees or ability to match an index. All of this is correct.
But then the article closes with this whopper from a well known financial planner
Investors also should weigh bond ETFs against actively managed mutual funds. Some financial advisers believe that actively managed funds are a better way to access the bond market, where many securities are thinly traded and pricing can be murky. While all of the bond ETFs now on the market track indexes, both Vanguard and Bear Stearns are hoping to launch actively managed fixed-income ETFs, according to regulatory filings.
Harold Evensky, a financial planner at Evensky & Katz in Coral Gables, Fla., uses active managers for the bond portion of client portfolios, partly because of the market's inefficiency and partly because bond ETFs don't cover municipal bonds, a key investment for many tax-sensitive investors.
Interestingly the WSJ and its sister publication, Smart Money Magazine have pointed out two reasons why the above is not at all the case:
1. The purpose in owning a bonds in a portfolio is to get a portfolio with a clearly defined maturity and risk level, otherwise one is really not getting exposure to the asset class characteristics of bonds. Furthermore just as no one can predict the future course of the stock market, no one can predict the future course for the bond market
An actively managed bond fund fails because you are depending on an active manager to “beat “ the bond market either by trading among maturities (predicting the course of interest rates) or among issuers (predicting the credit prospects for the issuer). For instance one of the most acclaimed bond fund managers Bill Gross of Pimco can move between foreign bonds currency hedged and unhedged,and domestic bonds across maturities and issuers in the Pimco Total Return Bond Fund. The investor in this fund is not gaining exposure to the bond asset class in any real sense, he is giving money to Bill Gross to trade as he sees fit in anything in the category of fixed income investments
As the WSJ’s sister publication Smart Money notes on its website:
Bond funds can be even trickier than bonds themselves because -- unlike the implication in their name -- they are not really fixed-income investments. Even when a mutual fund's portfolio is composed entirely of bonds, the fund itself has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date -- the two key fixed characteristics of individual bonds.
In addition, because fund managers constantly trade their positions, the risk-return profile of a bond-fund investment is continually changing: Unlike an actual bond, whose risk level declines the longer it is held by an investor, a fund can increase or decrease its risk exposure at the whim of the manager. In this way a bond fund is closer in character to equities than it is to individual bonds.
2. The other big reason to hold a bond index fund rather than an actively managed fund is that with the expected returns from the bond portion of a portfolio lower than the equity portion, actively managed fees in bond funds cut into an even higher portion of returns. As the WSJ’s excellent columnist wrote:
Why have bond-index funds fared so well? Partly, it's the expense advantage. While high-quality taxable-bond funds typically charge around 1% of assets each year, Vanguard's four bond-index funds have annual expenses of 0.2% or less, equal to 20 cents for every $100 invested.
"It's a durable advantage," says Ken Volpert, head of Vanguard's bond-indexing team. "It's there year after year after year."
That means the typical manager trying to outperform a bond-index fund is starting each year at a 0.8 percentage-point performance disadvantage. It's tough to make up that deficit, especially with bond yields so low.
"Bonds are where indexing really works," says William Bernstein, an investment adviser in North Bend, Ore. "Just as location, location and location are the most important things with real estate, so expense, expense and expense are the most important things with a bond fund."
A possible exception to the above might be rock bottom fee bond funds that are strictly limited as to issuer and maturity. One example would be the Vanguard Short Term Investment Grade Bond Fund which has strict parameters in maturity and credit quality and has a management fee of .21%. There are several others, but generally bond index funds or index etfs are the best choice for a portfolio, just as is the case for equities.
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