Chapter 15. Think Carefully About Managed Bond Funds
| Before turning to equity funds, let's consider the safer mutual funds, bond funds and money market funds. After all, this is a significant segment of the industry. We consider two issues here:
Let's consider the first issue from a historical perspective, and then examine how this situation has recently changed. Part of the traditional case for owning bond funds is that investors want a high-quality , safe, and conservative investment (i.e., they wish to own fixed-income securities) and indirect investing in bonds is easier and more efficient than direct investing in bonds. Traditionally it has not been easy to build a portfolio of fixed-income securities directly because bonds traded in relatively large quantities among professionals and little attention was devoted to the retail side, where average investors are involved. The bond market has been an institutionally oriented market, designed for professionals trading with professionals.
Brokerage firms act as dealers and quote a net price to investors, making it difficult to know if the price is "fair." Bonds do not trade with commissions; instead, a net price is quoted. Some discount brokerage firms such as Fidelity and Schwab do carry bond inventories for sale to investors. They collect a fee for bond transactions, but in actuality they also are collecting a spread between what they paid for the bonds and what they sell them for. The bottom line is that historically, it has always been difficult for investors to compare bond prices or verify the fairness of the price being paid because information was not available to do so. This led to the rise of bond funds. Bond funds take care of all the problems involved, and because they are buying and selling bonds in the institutional market, they obtain the best prices, which individuals typically could not. Bond funds offer diversification, assess credit risk, and take care of all of the other operating issues. When we consider that in the municipal bond market alone there are tens of thousands of different issuers, it is reassuring to know that there are professionals available to sort through these many possibilities and then deal with all the problems and issues that can arise. As always, there are some downsides to mutual funds, and this includes bond mutual funds. Investors must sort through a significant number of alternatives in choosing a fund and try to understand exactly what they are buying. Some bond funds also have risks that are not apparent to many investors. For example, some bond funds try to increase returns using derivative securities ”when interest rates decline, these funds might get a boost through the use of these financial instruments. If rates rise, however, returns can be adversely affected. Overall, the use of derivative securities can increase funds' risk, and often shareholders are not aware of this increased risk. As noted, historically the bond market was not a friendly environment for individual investors, thus favoring the use of bond mutual funds, but the Internet has changed this situation dramatically. Investors now have considerable access to bond information and quotes. In addition to research on bonds and the bond market (interest rates, yield curves, etc.), investors can obtain current bond prices for comparison. Furthermore, investors can now purchase bonds directly. This progress in the bond market will presumably continue, providing even more access to individual investors. At www.bondsonline.com, investors can access more than 12,000 current bond offerings of several types including STRIPS and CMOs. Using www.bondagent.com, investors can access more than 10,000 corporate, Treasury, and municipal bonds. At www.ebondtrade.com, investors can purchase municipals online and have them delivered to their brokerage account. Investors can trade bonds of all types and buy and sell CDs at www.bondpage.com. In summary, the traditional environment when it comes to bond investing has changed significantly in recent years . It is now much easier for investors to invest directly in bonds using the Internet: They can now access offerings, trade bonds on the Internet, and so forth. Nevertheless, many investors opt not to do so. It is still a daunting task, choosing from among thousands of bonds, understanding the terminology, worrying about credit risk (how financially sound is the company whose bonds you are buying?), and so forth. Now, we can consider the second issue. If investors are going to own bond mutual funds, and many are, should they pursue actively managed funds or bond index funds? Put simply, how strong is the case for actively managed bond funds? Do they offer advantages for investors that are worth paying for? If not, do they really deliver better results for investors than the alternatives? Before we consider actively managed funds, we need to understand that the alternative is to own a bond index fund. This is not the exact equivalent of an equity index fund because of all those bonds in existence, as mentioned earlier. A bond index fund cannot replicate a bond market index very readily because there are simply too many different bonds. Bond index funds attempt to match an index's performance by matching its key characteristics. These could include sector weights and yield curve characteristics, but in particular what is called duration . Bond investors will encounter this term if they do much in the way of investing, or read their shareholder reports or articles about bond investing, so it is worth taking a moment to consider what it is. It refers to the true economic life of a bond rather than simply its time to maturity. For example, two 10-year bonds, one with a 10 percent coupon and one with a five percent coupon , clearly do not have the same cash flow patterns over time, and hence do not have the same economic life. The case against many actively managed bond funds comes down to the costs of managing the funds. Bond portfolio performance is heavily influenced by the costs of managing the portfolio. Bond funds that attempt to mimic some bond index and keep their expenses low typically turn out to be the best performers. Why? First, bond returns are typically low, on the order of six, seven, eight, or nine percent. The typical bond mutual fund has an annual operating expense ratio of approximately one percent. Clearly, if bond expenses amount to one percentage point out of a total gross return of eight percentage points, that is a significant deduction when determining net results. Contrast that to the fund charging only one-half of a percentage point under the same circumstances. The second reason that costs matter so much for bond funds is that by and large comparable bond funds ”for example, two funds specializing in long-term Treasury securities ”are selecting bonds from the same basic pool. There is not much differentiation in what they end up holding, and therefore, what they can earn for shareholders. The compound annual average rate of return on Treasury bonds from 1920 to 2000 was 5.25 percent, whereas for corporate bonds the average rate over the same period was 5.84 percent. In such an environment, costs make a big difference in the final results because there is not all that much return to work with. Put simply, bond index funds tend to outperform actively managed bond funds, primarily because index funds have lower costs. Consider some evidence from Vanguard, the leader in the industry in offering low-cost bond funds. Table 15-1 shows the rates of return for Vanguard's Total Bond Market Index Fund, started at the end of December 1986. This fund seeks to track the Lehman Brothers Aggregate Bond Index, which in turn is a proxy for the overall U.S. bond market. Results cover the period from inception to June 30, 2001. [1]
Table 15-1. Average Annual Total Returns, Periods Ending 6/30/2001
Vanguard's bond index fund outperformed the average intermediate-term government fund for each comparison period shown in Table 15-1 because of its low costs, which other funds do not match. This index fund outperformed 96 percent of its competitors during the first half of 2001 and for the previous three years through June 2001. Vanguard's Total Bond Market Index Fund has an operating expense ratio of only 0.2 percent (i.e., .002 of assets). Actively managed funds do not come close to this, and therefore more is subtracted from the gross return of the actively managed funds before shareholders receive their take. Consider the current interest rate environment. Treasury securities are paying relatively low rates, and investment-grade paper has a yield in the six percent range. In such an environment, the costs of managing bond funds have a major impact on net performance. It is thus difficult now to make a strong case for actively managed bond portfolios. Bond index funds outperform most managers of bond funds, most of the time, because of lower expenses. A few funds might add slight value through "return enhancements," but this is difficult to do. Keep in mind that there are two separate questions with regard to mutual funds and bonds. Investors should address both of these issues. First is the question of whether investors should own bond mutual funds or build their own bond portfolios. Despite the changing nature of the bond market brought about by the rise of the Internet, investors still might feel they are unable to easily construct a good bond portfolio, given all the issues with which they must contend. It is easier, and many would say, more efficient and effective, for investors to turn their money over to the professionals at the mutual fund companies and let them do the investing. Second, having made the decision to own bond mutual funds, should investors seek the best bond managers in the expectation that these managers will achieve superior returns? Here the case is much more shaky. You might find bond fund managers that excel, but the odds are against you. For the typical investor, over longer periods of time, index funds are likely to win out because of their lower costs.  |
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