Bonds are an asset class that most investors know that they need to include in their portfolios for diversification and allocation reasons, but don’t know much about otherwise.
Simply labeling bonds as conservative investments that are needed in a portfolio to keep it balanced can mean missing out on more profitable opportunities at best, and subjecting your portfolio to more risk than necessary at worst.
The Breakdown: Bond Mutual Funds
Bond mutual funds aren’t that dissimilar from equity mutual funds. Both come with a portfolio of assets and professional management that selects what assets to hold and how they should be weighted. For most investors, the idea of professional management in a bond portfolio is all they need to know. After all, it’s one less asset class to have to learn about and follow in the market.
Having professional management is arguably the biggest advantage of holding a bond fund. Instead of designing a bond portfolio on your own, a mutual fund invests in a variety of bonds to create a diverse portfolio.
But bond funds have a downside that investors often overlook. While cheaper on average compared to equity funds, bond funds still come with expense ratios. Considering that the average 5-year return for long-term bond funds is currently 4.90% and short-term bond funds are only producing 1.20%, even a small fee can take up a considerable amount of an investor’s profits.
In response to investor displeasure at fees, bond funds have been decreasing fees in order to keep investors and attract new ones. In 2000, the average expense fee for a bond fund was 0.76% – as of 2017, the fee was only 0.48%.
Another criticism of the bond fund industry, and the mutual fund industry in general, has been the lack of performance. Especially in light of the rising interest rate environment, bond funds have typically underperformed, with returns that hover near zero percent for the year. Interestingly though, in 2017, when interest rates jumped to finish the year at around 2.45%, net inflows for bond funds hit $260 billion – double that of 2016.
There are more than just stock or bond funds to choose from. Click here to learn more about choosing the right commodity mutual fund for your portfolio.
The Breakdown: Bond ETFs
Exchange Traded Funds (ETFs) are one of the fastest-growing investment vehicles on the market. Its popularity keeps climbing as investors realize how much versatility ETFs add to a portfolio. Like stocks, these investment vehicles come with a high degree of liquidity and can be traded during market hours in the same manner.
One interesting aspect of ETFs is the fact that they can be shorted like stocks can. That means that investors can use bond ETFs to short bonds. For example, because bond prices and yields are inversely correlated, investors may decide to short a bond ETF if they anticipate rising yields.
ETFs do come with expense ratios like mutual funds do, although the fees are generally lower due to the fact that many ETFs don’t come with an active management structure. However, things started changing at the beginning of 2012 when fixed-income expert PIMCO introduced PIMCO Active Bond ETF (BOND) – one of the first bond ETFs that was actively managed. BOND currently has more than $1.8 billion in assets under management. As of writing this article, BOND had an AUM of nearly $1.9 billion. As of September 30, 2018, the ETF produced an annualized return of 2.78% over the last 5 years.
Another interesting aspect of bond ETFs is that unlike bond funds, expense ratios have actually trended higher over the past decade. In 2007, the average fee for an index bond ETF was 0.18% – as of 2017, the average fee stood at 0.29%. Note that it’s still about half of what is found in bond mutual funds.
In the current interest rate environment, bond funds have outperformed traditional passively managed bond ETFs. For example, the largest bond ETF, iShares Core US Aggregate Bond ETF (AGG) actually lost around 1.90% over a 5-year time frame. At the same time, bond ETF issuers can have more flexibility while designing new products. For instance, ETF issuers like iShares have adopted rules-based smart beta strategy in its bond ETF iShares Edge U.S. Fixed Income Balanced Risk ETF (FIBR) designed to generate income through a diversified portfolio of U.S. bonds by balancing interest rate and credit risk. The rules-based strategy seems to have paid off, at least when compared to a traditional plain vanilla bond ETFs like AGG. As of September 30, 2018, the ETF – which has an AUM of nearly $115 million – produced an annualized return of 2.17% since its inception in February 2015.
The State of the Industry
Total assets under management for the U.S. mutual fund industry was $18.7 trillion as of 2017 – the largest in the world. Despite the growing popularity of ETFs, the addition of target-date funds has helped attract and keep investors. Like previously mentioned before, bond fund inflows totaled $260 billion as of 2017 – double that of the year prior, led mainly by investment grade bond funds.
Totaling more than 1,832 different ETFs by the end of 2017, total assets under management for the ETF industry came in at $3.4 trillion. With global ETF assets at $4.7 trillion, the U.S. ETF market is by far the largest in the world, but it is still only around a fifth of what the mutual fund industry holds. In 2017, bond ETF issuance was up to $120 billion – a considerable jump from $83 billion in 2016.
There’s been a building trend of mutual fund outflows and ETF inflows over the past couple of years as investors flee underperforming assets and high fees for a cheaper alternative. In 2005, total net assets for ETFs was only $301 billion compared to the $3.4 trillion it was at by the end of 2017. From a growth perspective, in general, ETFs have been beating out mutual funds for investors’ attention.
Be sure to read this to learn more about the differences between ETFs and mutual funds.
The Bottom Line
Picking between a bond fund or bond ETF isn’t done by simply flipping a coin to see which wins out. Depending on an investor’s market knowledge and portfolio needs, one choice may be more beneficial than the other. Conservative investors who don’t have a lot of time on their hands may prefer the professional management that bond funds offer. Investors that like to take a more active role, however, may find ETFs more appropriate. Before making a decision, investors should carefully weigh out the pros and cons of each bond investment vehicle to determine which one is right for them.