|Can 3 Bond Funds Out­per­form 1?

Bond funds go mano a mano in the last in­stall­ment of this 3-part se­ries on max­i­miz­ing to­tal-mar­ket in­dex funds.

Financial Planning - - CONTENT - By Craig L. Is­raelsen

Bond funds go mano a mano in the last in­stall­ment of a 3-part se­ries on max­i­miz­ing to­tal-mar­ket in­dex funds.

OVER THE PAST FEW MONTHS, I’VE TAKEN YOU ON A jour­ney to ex­am­ine the strengths — and lim­its — of to­tal­mar­ket funds.

My quest was to an­swer th­ese ques­tions: Can a sin­gle fund that in­vests in U.S. stocks out­per­form a care­fully se­lected col­lec­tion of three in­dex funds cho­sen to cover the cor­re­spond­ing as­set group? Is the same true when we ex­am­ine a sin­gle fund of non-u.s. stocks? In both cases, the an­swer was no.

Now I set my sights on bonds. Can a sin­gle U.S. to­tal bond fund out­per­form a trio of bond funds that col­lec­tively cover the same bond cat­e­gories? Here’s why it mat­ters: do­mes­tic bond funds face an up­hill bat­tle as in­ter­est rates are likely to rise in the com­ing years. Thus, any­thing you can do to en­hance the per­for­mance of the bond por­tion of your client’s port­fo­lio is worth in­ves­ti­gat­ing.

I make my first stop at Van­guard. To cover the broad U.S. bond mar­ket, the firm has a one-stop of­fer­ing for in­vestors wish­ing to sim­plify their ex­po­sure to the U.S. bond mar­ket. Its fund, the Van­guard To­tal Bond Mar­ket In­dex (VBMFX), cur­rently has a 40% al­lo­ca­tion to U.S. gov­ern­ment bonds, a 25% al­lo­ca­tion to gov­ern­ment mort­gage-backed se­cu­ri­ties (GNMA) and a 35% al­lo­ca­tion to U.S. cor­po­rate bonds.

This type of fund is cer­tainly convenient, but does it of­fer the best ap­proach?

A THREE-FUND OP­TION

Another ap­proach would be to in­vest in sep­a­rate bond funds from each dis­tinct seg­ment: a gov­ern­ment bond fund, a Gin­nie Mae fund and cor­po­rate bond fund. For our ex­plo­ration, I’m us­ing Van­guard In­ter­me­di­ate-term Trea­sury (VFITX), Van­guard GNMA (VFIIX) and Van­guard In­ter­me­di­ate-term In­vest­ment-grade (VFICX).

When com­bined, th­ese three funds seek to ac­com­plish (at least in the­ory) what the Van­guard To­tal Bond Mar­ket In­dex is try­ing to achieve. Thus, this study com­pares the per­for­mance of one sin­gle mega in­dex bond fund against the com­bined per­for­mance of three sep­a­rate bond funds, which are re­bal­anced an­nu­ally. The time frame for this study was the 18-year pe­riod from Jan. 1, 1999 to Dec. 31, 2016. Per­for­mance data were ex­tracted from the Steele Sys­tems mu­tual fund data­base.

The an­nual re­turns of the three bond funds are shown in the chart “Three­some Ver­sus Stand-alone.” Also shown is the an­nual per­for­mance of the Van­guard To­tal Bond Mar­ket In­dex.

Over the full course of the study, each in­di­vid­ual bond fund had bet­ter per­for­mance than the VBMFX, but in some cases this ad­van­tage was very slight.

The largest gap was 83 ba­sis points be­tween VFICX, the cor­po­rate bond fund, and VBMFX. Over 18 years, this re­sulted in an end­ing bal­ance that was larger by al­most $3,500, as­sum­ing an ini­tial in­vest­ment of $10,000.

A YEAR WORTH EX­AM­IN­ING

To fo­cus on one sem­i­nal year, note the per­for­mance of each fund in 2008. VFITX was the clear win­ner with a one-year re­turn of 13.32%, with VFIIX a dis­tant sec­ond at

7.22%. VBMFX gen­er­ated a pos­i­tive re­turn of 5.05% whereas VFICX had a loss of 6.16% in 2008.

I have called your at­ten­tion to 2008 to make a point. When us­ing three sep­a­rate funds, there are more so-called buck­ets from which to with­draw money. Of course, we try to avoid with­draw­ing money from a fund if it has had a neg­a­tive year.

But if you are us­ing a to­tal-in­dex fund, there is only one bucket — even though the bucket con­tains sev­eral dif­fer­ent bond ex­po­sures.

What’s more, if the over­all re­turn is neg­a­tive (as in 1999 and 2013) and the in­vestor has to with­draw money that year, the loss will be ex­ac­er­bated. If, how­ever, there were more buck­ets to with­draw money from, the in­vestor could pull the money out of whichever fund had the best re­turn. In 1999, that would have been the Gin­nie Mae fund (VFIIX).

I re­fer to this phe­nom­e­non as dis­trib­uted per­for­mance ver­sus con­cen­trated per­for­mance.

A one-fund to­tal-mar­ket so­lu­tion is sub­ject to con­cen­trated per­for­mance and is there­fore more vul­ner­a­ble to the tim­ing of with­drawals dur­ing mar­ket down­turns. A com­bi­na­tion of funds pro­duces sep­a­rate re­turns (that is, dis­trib­uted per­for­mance) and is likely to be less vul­ner­a­ble to port­fo­lio with­drawals dur­ing a gen­eral bond mar­ket down­turn.

CRE­AT­ING A MIX

The im­por­tant com­par­i­son, how­ever, is the mix of the three funds against the to­tal bond mar­ket in­dex fund.

As shown in the chart “Seek­ing an Ideal Mix,” the three-fund mix­tures each pro­duced bet­ter a 18-year per­for­mance than the to­tal bond mar­ket in­dex. But this ad­van­tage over Van­guard To­tal Bond Mar­ket In­dex was rel­a­tively mod­est.

More­over, the three­somes have high cor­re­la­tion with VBMFX and a slightly higher over­all ex­pense ra­tio (20 ba­sis points) that the to­tal bond in­dex, whose ex­pense ra­tio was only 15 ba­sis points.

In ad­di­tion, the beta co­ef­fi­cient for the Van­guard-weighted three­fund ap­proach was 1.13, which in­di­cates that it is 13% more volatile than VBMFX. When the three bond funds are equally weighted, the beta co­ef­fi­cient dropped slightly to 1.11 — still 11% more volatile than VBMFX.

How­ever, in both cases, the mod­est amount of added volatil­ity when us­ing three bond funds in­stead of

one mega in­dex had a pay­off — 45 bps of higher per­for­mance with the Van­guard weight­ing and 43 bps when hold­ing each fund in an equal al­lo­ca­tion of 33.33% (and re­bal­anc­ing yearly in both cases).

De­spite slightly lower per­for­mance, when it comes to the fixed­in­come port­fo­lio of your clients’ over­all port­fo­lio, the con­ve­nience of us­ing a sin­gle to­tal bond mar­ket in­dex fund (such as VBMFX) may be com­pelling.

A POS­SI­BLE TIP­PING POINT

But per­haps the tip­ping point in de­cid­ing which ap­proach to use may be the is­sue of dis­trib­uted per­for­mance ver­sus con­cen­trated per­for­mance.

When us­ing three sep­a­rate bond funds (or more if you de­cide that ad­di­tional funds will mean­ing­fully en­hance the di­ver­si­fi­ca­tion of the fixed-in­come por­tion of the over­all port­fo­lio), you have more buck­ets from which to with­draw money. And that is al­ways a ben­e­fi­cial op­tion when it comes to pre­serv­ing the value of a port­fo­lio dur­ing tur­bu­lent mar­kets.

If all bond funds had sim­i­lar per­for­mance, there would be no need to use sev­eral of them. But, as clearly shown in “Three­some Ver­sus Stand­alone,” there was of­ten sub­stan­tial per­for­mance vari­a­tion among the three bond funds.

When con­sid­er­ing the wide va­ri­ety of bond funds be­yond the three that are il­lus­trated in the ta­ble, we can safely con­clude that dis­trib­uted per­for­mance is a pru­dent ap­proach when deal­ing with bond funds.

Thus, if the rel­a­tively slight per­for­mance ad­van­tage of us­ing three sep­a­rate bond funds doesn’t con­vince you, the ad­van­tage of hav­ing dis­trib­uted per­for­mance in the fixed-in­come por­tion of your client’s in­vest­ment port­fo­lio just may.

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