5 More Reasons We Favor Bond Funds

03/14/2013 9:45 am EST

Focus: BONDS

Janet Brown

President, FundX Investment Group

While ETFs get all the love from investors, Janet Brown of NoLoad FundX explains why she prefers bond funds, in most cases.

We’ve embraced ETFs in our equity portfolios, where we invest in both highly ranked funds and ETFs, but in our fixed income portfolios, we tend to select mutual funds over ETFs. This may surprise some investors, considering that current low interest rates make the generally lower expenses of ETFs even more compelling. Here are some of the factors that lead us to tip the scales in favor of traditional fixed income mutual funds.

  1. Bond funds add value through active management. One tenet of index investors is that few active managers beat their benchmark index over time, but that’s not the case in fixed income. Just as important, active fixed income managers make risk management a priority, which helps reduce default rates and improve recovery results. Actively managed funds can also consider investing in less widely traded bonds that index-based ETFs may not have access to.

  2. Bond funds have proven track records, but bond ETFs are relatively new. The oldest is just six years old, and most are less than three years old. Bond mutual funds, on the other hand, have been around for decades. And bond funds that are designed to track major indexes have rarely been top performers.

  3. Bond funds can’t be sold short but bond ETFs can. Essentially, hedge fund managers and other active traders can buy individual bonds that they like and then hedge their overall bond market exposure by short selling an index-based ETF. This can lead to increased volatility in ETFs—especially for those that trade high-yield bonds. Bond ETFs are generally more volatile than bond funds, and one of our goals in managing fixed income is to limit volatility.

  4. Bond funds trade at NAV (net asset value). ETFs have arrangements with market makers to provide liquidity, and ETFs can be traded throughout the trading day. But there is no guarantee that ETFs will trade at the value of their underlying net assets. Bonds are more expensive to trade than stocks, so most bond ETFs typically trade slightly above NAV to compensate ETF market makers for these added trading costs. In a down market, these same bond ETFs may trade below NAV, sometimes substantially, when there are more sellers than buyers and market makers are unwilling to bring the ETFs back to NAV. Bond funds always trade at NAV, so you don’t ever pay a premium at the time of your purchase and you also don’t risk selling below NAV if you sell into a down market.

  5. Bond funds have offered better risk-adjusted performance. Consider the Vanguard Total Bond Market Fund, which has both a mutual fund share class (VBMFX) and an ETF share class (BND). Since both tickers represent the same fund portfolio, they should have identical performance, and over time, they do. But BND is more volatile, partly for the reasons described above. Why accept greater volatility if you don’t get compensated by better performance? High yield bond funds like Janus High-Yield (JAHYX) or Fidelity High Income (SPHIX) have consistently performed better than high yield ETFs like SPDR Barclays Capital High Yield (JNK) and iShares iBoxx High Yield (HYG) and with less volatility.

Although we generally prefer bond funds, we do use some bond ETFs at times. For example, if we add to junk bonds in times of stress, we may buy JNK when it is trading at a discount. We also use bond ETFs in categories that are less volatile, like very short-term Treasuries where lower expenses add the most value. And some of the newer bond ETFs show signs of being real competitors for bond funds down the road. However, we tend to err on the conservative side as we manage risks and seek consistent positive performance.

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