Recognizing the great differences among fund types
Cutting through the hype and focusing on what matters
For the vast majority of individual investors, funds are the way to go. That was true several years ago, and it’s even truer today with the advent of nearly 300 bond exchange-traded funds (ETFs) that allow the small investor ready access to some darned good and ultra low-cost bond portfolios.
There’s nothing wimpy about bond funds, and provided you do your homework, they can be as intelligent and sophisticated an investment vehicle as you’ll ever find. (Index funds, which include most of the fixed-income ETFs, are seen by some as the wimpiest things under the sky but turn out to be mighty tough themselves.)
In this chapter, we introduce you to the many kinds of bond funds — index, active, mutual funds, ETFs, closed-end funds, and unit investment trusts — and reveal that although none are worth dying for, some may well be worth fighting for.
Defining the Basic Kinds of Funds
With hundreds upon hundreds of bond funds to choose from, each representing a different basket of bonds, where do you start? That part is actually easy: You start with the particular class of bonds you want to own. Treasuries? Corporate bonds? Munis? Long-term? Short-term? Investment-grade? High-yield? A blend of all of the above? And knowing what class of bonds you want in the basket isn’t enough. You also need to know what kind of basket
you want.
Bond baskets (funds) come in five varieties:
Open-end mutual funds, typically referred to simply as mutual funds,
are far and away the most common.
Closed-end mutual funds, usually referred to only as closed-end funds,
offer comparatively greater return for greater risk.
Exchange-traded funds (ETFs) are the newer kids on the block, catching on very quickly — for good reason.
Unit investment trusts are not well known but perhaps worth knowing.
Exchange-traded notes (ETNs) are sort of bonds within bonds with bells and whistles and their own unique characteristics.
Table 5-1
offers an overview of how these types of funds compare. In the following sections, we provide the details.
When most investors speak of funds, they’re talking about mutual funds. And it’s no wonder. According to Morningstar, the total number of distinct mutual funds (ignoring different share classes of certain mutual funds) clocks in at an astounding 7,700. Of those 7,700 funds, 1,964 of them — over one quarter — represent baskets of bonds.
Like all funds, a mutual fund represents a collection of securities. You, as the investor, pay the mutual fund company a yearly fee and sometimes a sales charge (called a load
) to buy the fund. In exchange for your money, the mutual fund company offers you an instant portfolio with professional management.
Most mutual funds are open-end
funds. This means that the number of shares available is not limited. Within reason, as many people who want to buy into the fund do so. As more people buy into the fund, more bonds are purchased. The mutual fund shares then sell at a price that directly reflects the price of all the bonds held by the mutual fund. The interest you receive from the fund is a pro rata
portion of the total interest received by all the bonds in the basket, minus whatever management fees are taken out.
Mutual fund orders can be placed at any time, but they are priced only at the end of the day (4 p.m. on Wall Street), and that’s the price you get. If you place an order to buy after 4 p.m., the trade is executed at the next day’s closing price.
Most mutual funds are actively managed, which means that the managers try to beat the broad bond market by picking certain issues of bonds or by trying to time the markets. Other mutual funds are passively run, or indexed,
which means they are set up to track standard fixed-income indexes. Index funds tend to cost you a lot less in fees than actively managed funds.
Regardless of whether you go with active or passive, choose only those bond mutual funds that have solid track records over several years and are reasonably priced. The average yearly operating expense of a bond mutual fund, per Morningstar, is 0.97 percent. Because total return on bond funds, over time, tends to be less than that of stock funds, the cost ratio is usually a bigger factor. We wouldn’t touch anything over 1 percent without a very compelling reason to do so. You likely don’t need to buy more expensive funds; you have many inexpensive alternatives to choose from, and they tend to offer better performance over time.
Considering an alternative: Closed-end funds
Most mutual funds are open-ended, and some are not. The closed-end funds are a universe unto themselves. Unlike open-end funds, closed-end funds have a finite
number of shares. The price of the fund does not directly reflect the value of the securities within the fund. Nor does the yield directly reflect the yield of the bonds in the basket. In investment-speak, the net asset value
(NAV) of the fund, or the price of the securities within the fund, may differ significantly from the price of the fund itself.
Supply and demand for a closed-end fund may have more bearing on its price than the actual securities it holds. Closed-end funds tend to have high management fees (almost always more than 1 percent a year), and they tend to be more volatile than open-end funds, in part because they are often leveraged. Closed-end funds are traded like stocks (yes, even the bond closed-end funds), and they trade throughout the day. You buy and sell them through any brokerage house — not directly from the mutual fund company, as you can do with most mutual funds.
All closed-end funds are actively managed. There are more than 600 closed-end funds, of which nearly two-thirds are bond funds. The average yearly fee of these bond funds, per Morningstar, is a relatively chunky 1.27 percent. We suggest that if you do buy a closed-end fund, you choose one selling at a discount to the NAV, not at a premium. Studies show that discounted closed-end funds tend to see better performance (similar to value stocks outperforming growth stocks).
Establishing a position in exchange-traded funds
Although relatively new, exchange-traded funds (ETFs) have caught on big in the past several years. ETFs, like closed-end funds, trade on the exchanges like individual stocks. (Yes, even the bond ETFs trade that way.) You usually pay a small brokerage fee ($10 or so) when you buy and another when you sell. But while you own the fund, your yearly fees are very low; they are, in fact, a fraction of what you’d pay for a typical bond mutual fund, closed-end fund, or any other kind of fund.
Unlike closed-end funds, ETFs usually maintain a price that closely matches the net asset value, or the value of all the securities in the portfolio. However — at least at the present time — the vast majority of ETFs are index funds, unlike both closed-end and mutual funds. About 11 percent (261) of all 1,441 ETFs available to U.S. investors are bond ETFs.
There aren’t as many fixed-income ETFs relative to mutual funds, but we predict that the number will continue to expand. Their popularity is in part due to their super low expense ratio. The average bond ETF charges only 0.30 percent a year in operating expenses, and a good many are less than 0.20 percent.
Stock ETFs tend to be much more tax-efficient than stock mutual funds. In the bond arena, the difference isn’t as great. ETFs tend to be lower cost, but you may have to deal with small trading commissions. And at times the net asset value of your ETF’s securities may rise above, or fall below, the market price. This flux shouldn’t be a major concern to buy-and-hold investors.
Understanding unit investment trusts
A unit investment trust (UIT) is a bundle of securities handpicked by a manager. You buy into the UIT as you would an actively managed mutual fund. But unlike the manager of the mutual fund, the UIT manager does not actively trade the portfolio. Rather, he buys the bonds (or in some cases, bond funds), perhaps 10 or 20 of them, and holds them throughout the life of the bonds or for the life of the UIT.
A UIT, which may contain a mix of corporate bonds, Treasuries, and munis, has a maturity date — it could be a year, 5 years, or even 30 years down the road. Interest payments (or principal payments, should a bond mature or be called) from a UIT may arrive monthly, quarterly, or semi-annually. Management expenses for a UIT range from 0.2 to 1 percent, and you also pay a commission of about 1 to 3 percent when they’re bought. (You don’t pay anything when you sell them.) Contact any major brokerage house if you’re interested.
Should you be interested?
“A UIT can give you the diversification of a mutual fund as well as greater transparency by knowing exactly what bonds are in your portfolio,” says Chris Genovese, senior vice president of Fixed Income Securities, a nationwide firm that provides targeted advice on bond portfolio construction to investment advisors. “They are certainly appropriate for many individual investors, whether in retirement accounts or investment accounts.” UITs come and go from the marketplace, explains Genovese. “If you are interested in seeing the currently available selection, talk to your broker. Look at the prospectus. As you would with any other bond investment, weigh the benefits and the risks of the bonds in the portfolio, and determine if it looks like the right mix for you.”
Bond ETFs can also give you the diversification and transparency of a UIT, but only a handful of bond ETFs offer target maturity dates, as UITs do.
Taking a flyer (or not) on an exchange-traded note
Although they sound alike, exchange-traded notes and exchange-traded funds are hugely different. ETNs, which trade just like ETFs or individuals stocks, are
debt instruments. The issuer, a company such as Direxion or PowerShares or Barclays (all big players in the ETN game), issues an ETN and promises shareholders a rate of return based on the performance of X. What is X? It could be the price of a commodity, or the value of a certain currency, or the return on a certain bond portfolio.
Unlike ETFs, the underlying investments (bonds, commodities, what have you) are not necessarily owned by the issuer of the ETN.
ETNs have been proliferating of late, with dozens having popped up in the past few years. Of these, only a handful are based on any simple and recognizable index of bonds. All the other bond ETNs, currently 37, give you exposure to bonds in a strange, distorted fashion, typically offering you either a doubling or tripling of the bonds’ returns or, conversely, the inverse of the bonds’ performance. For instance, if Treasuries lose 3 percent tomorrow, some ETNs will go up 3 percent in value. Others may go up 6 percent … or 9 percent.
Although bond ETNs have one big advantage over ETFs (they are generally taxed more gingerly), they really are not very good vehicles for bond exposure. As noted earlier in this discussion, these are debt instruments. As such, when you buy an ETN issued by, say, JP Morgan, you may be taking on double credit risk. You need to worry about the credit worthiness of those who issue the bonds in the portfolio, as well as the credit worthiness of PowerShares itself. This is not the case with ETFs.
More troubling is the nature of the beast itself. Yes, a leveraged ETN may double or triple your money, but read the fine print! The doubling or tripling is done on a daily
basis. The strange mathematics of daily returns means that you will lose money over the long run. Trust us on this. You will lose money over the long run.
Your principal will simply be eaten away by the extreme volatility.
What Matters Most in Choosing a Bond Fund of Any Sort
For years, alchemists tried to turn common metals into gold. It can’t be done. The first rule to follow when choosing a bond fund is to find one appropriate to your particular portfolio needs, which means finding a bond fund made of the right material. After all, bond fund managers can’t do all that much more than alchemists.
Selecting your fund based on its components and their characteristics
If you’re looking for a bond fund that’s going to produce steady returns with little volatility and very limited risk to your principal, start with a bond fund that is built of low-volatility bonds issued by credit-worthy institutions. A perfect example would be a short-term Treasury bond fund. If you’re looking for kick-ass returns in a fixed-income fund, start looking for funds built of high-yield fixed-income securities.
One of the main characteristics you look for in a bond is its tax status. Most bonds are taxable, but municipal bonds are federally tax-free. If you want to laugh off taxes, choose a municipal bond fund. But just as with the individual muni bonds themselves, expect lower yield with a muni fund. Also pick and choose your muni fund based on the level of taxation you’re looking to avoid. State-specific municipal bond funds filled with triple-tax-free bonds (free from federal, state, and local tax) are triple-tax-free themselves.
Pruning out the underperformers
Obviously, you want to look at any prospective bond fund’s performance vis a vis
its peers. If you are examining index funds, the driving force behind returns will be the fund’s operating expenses. Intermediate-term Treasury bond index fund X will generally do better than intermediate-term Treasury bond index fund Y if less of the profits are eaten up by operating expenses.
With actively managed funds, guess what? Operating expenses are also a driving force. One study conducted by Morningstar, reported in The Wall Street Journal,
looked at high quality, taxable bond funds available to all investors with minimums of less than $10,000. More than half of those funds charge investors 1 percent or more. Not surprisingly, almost three-quarters of those pricier funds showed performance that was in the bottom half of the category for the previous year.
Don’t pay more than 1 percent a year for any bond fund unless you have a great reason. And don’t invest in any actively managed bond fund that hasn’t outperformed its peers — and any proper and appropriate benchmarks — for at least several years. (By “proper and appropriate benchmarks,” we’re referring to bond indexes that most closely match the composition of the bond fund in question. A high-yield bond fund, given that you can expect more volatility, should
produce higher yields than, say, a Treasury index. Any comparison of a high-yield fund’s return to a Treasury index is practically moot.)
Laying down the law on loads
An astonishing number of bond funds charge loads. A load
is nothing more than a sales commission, sometimes paid when buying the fund (that’s called a front-end
load) and sometimes paid when selling (that’s called a back-end
or deferred
load). Our advice? Never pay a load
. There is absolutely no reason you should ever pay a load of (not unheard of) 5.5 percent to buy a bond fund. The math simply doesn’t work in your favor.
If you pay a 5.5 percent load to buy into a fund with $10,000, you lose $550 up-front. You start with an investment of only $9,450. Suppose that the fund manager is a veritable wizard and gets a 7 percent return over the next five years, whereas similar bond funds with similar yearly operating expenses are paying only 6 percent. Here’s what you’ll have in five years with the load fund, even though there’s a wizard at the helm: $13,254. Here’s what you’d have with the no-load fund, assuming the manager is merely average: $13,382.
Buying a load bond fund is plain and simple dumb. Unless you get some kind of special deal that allows for the load to be waived, don’t buy load funds. Repeat: Don’t buy load funds.
Sniffing out false promises
Although morally dubious, and in some cases even illegal, some brokerage houses and financial supermarket websites have been known to promote certain bond funds over others not because those funds are any better but because a certain fund company paid to be promoted. (In the industry, this is sometimes known as “buying shelf space.”) Buyer beware!
“Investors need to fully understand how their broker is being compensated, and if a firm is promoting certain bonds or bond funds, investors should ask if the firm is being compensated for that promotion,” says Gerri Walsh, vice president for investor education with the Financial Industry Regulatory Authority (FINRA).
Recognizing the great differences among fund types
Regardless of whether you go with active or passive, choose only those bond mutual funds that have solid track records over several years and are reasonably priced. The average yearly operating expense of a bond mutual fund, per Morningstar, is 0.97 percent. Because total return on bond funds, over time, tends to be less than that of stock funds, the cost ratio is usually a bigger factor. We wouldn’t touch anything over 1 percent without a very compelling reason to do so. You likely don’t need to buy more expensive funds; you have many inexpensive alternatives to choose from, and they tend to offer better performance over time.
There aren’t as many fixed-income ETFs relative to mutual funds, but we predict that the number will continue to expand. Their popularity is in part due to their super low expense ratio. The average bond ETF charges only 0.30 percent a year in operating expenses, and a good many are less than 0.20 percent.
Although bond ETNs have one big advantage over ETFs (they are generally taxed more gingerly), they really are not very good vehicles for bond exposure. As noted earlier in this discussion, these are debt instruments. As such, when you buy an ETN issued by, say, JP Morgan, you may be taking on double credit risk. You need to worry about the credit worthiness of those who issue the bonds in the portfolio, as well as the credit worthiness of PowerShares itself. This is not the case with ETFs.