More On The Risks in Actively Managed Bond Funds

I wrote on May 19 about how using an active, as opposed to passively managed bond fund can be very dangerous to your portfolio. Even though most writing about indexing deals with equities, an article in the WSJ's monthly review on fund investing highlights that indexing is crucial for bond investing as well.


my bolds, my comments in bold italicsFUND FIEND

No Diversification: How Bond Funds Let Investors Down

By TOM LAURICELLA

Losses in bond mutual funds last year caught many investors off guard. But the warning signs were there, and the performance of those funds provides a cautionary note about how much—or how little—cushion they offer against a big drop in the stock market.

Theoretically, bond funds should have been a haven from the bear market in stocks. The most widely used investment-grade bond-market benchmark, the Barclays Capital Aggregate Index (formerly the Lehman Aggregate), gained 5.2% in 2008. Yet the average intermediate-bond fund—the Morningstar Inc. category closest to the index—lost 4.7%.

And the amount by which funds fell far outstripped the gains of top performers. Funds in the bottom 95% of peers trailed the index by an average 20.7 points—losing about 15%—while those in the top 5% beat the index by a meager 1.2 points.

What went wrong? Most intermediate funds held far fewer of the safest bonds than were inthe index. Worse, as the credit crisis unfolded and prices of risky bonds collapsed, many managers boosted holdings of low-quality debt.

As of June 2006, the average intermediate-bond fund had 64% of assets in triple-A-rated securities. By June 2008, that was down to 62%, Morningstar says. Meanwhile, within the index, the percentage of triple-A debt was moving higher, to 75.5% as of June 2008, Morningstar says. The average intermediate-bond fund held at least 5% in junk bonds—while the Barclays index has none. “They were all buying credit risk and they were all buying liquidity risk,” says Michele Gambera, chief economist at Ibbotson Associates. “It’s been an expensive eye-opener for the industry and investors.”

I will offer another explanation for the above. Many many bond fund investors seek the highest yielding funds within a given category. Bond fund managers know this, and they are compensated based on the assets under management in their fund. Thus I am not surprised that active fund managers would move to riskier higher yielding assets in the quest to gain assets and push themselves to the top of the listings in terms of yields. And as the paragraph below notes, the strategy seldom works to the investors' favor.

On the one hand, these managers aren’t collecting big salaries for simply mimicking an index. But since 1999, there’s been only one year when the average fund topped the index. That was 2003, when the stock market was starting a rebound.

It just so happens that this year the average intermediate-bond fund is ahead of the index. But is it worth owning a fund that may outperform only when the stock market is recovering? That isn’t much help in diversifying a portfolio.

It may be yet another reason to buy an index fund: to know what you’re getting

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The last line is of course the most crucial one. In allocating the bond portion of a portfolio the quest is usually for less risky assets to counter the riskier portions of the portfolio in equities and other asset classes. In my view this should include only conventional treasuries, inflation protected treasury bonds, and government agency and high grade corporate bonds with maturities of at most five years to limit interest rate risk. To illustrate this point take a look at the chart at the top of the page and compare the volatility of the exchange traded fund for treasuries 20 yrs+ in maturity (TLT in black) to the 1 -3 year treasury etf in brown.

(High yield bonds if held at all would be considered part of the equity allocation given their risk/return characteristics).

Therefore it is crucial that the funds chosen to implement the bomb allocation must be transparent and that its holdings match the goals for the portfolio allocation. As pointed out in the article above and in a manner similar to equity funds the mere label for the fund does not give sufficient guarantees as to the content of the fund. For that reason bond index funds or bond exchange traded funds which have fixed allocations to specific parts of the bond market are the best way to implement a bond allocation. I wrote earlier about the problems with "go anywhere" bond funds that can invest in literally any kind of fixed income instrument in any country, currency, maturity, or credit rating. The article above shows that even if one picks an actively managed bond mutual fund with a more limited strategy indicated in its title, there still may be problems.