Parsing the bond fund dilemma
Conventional wisdom says we should all have some fixed-income securities in our portfolios. They don’t provide great returns, but they act as a cushion in the event of a stock market collapse.
According to the Steadyhand Volatility Meter, an asset mix of 90 per cent stocks, 10 per cent bonds would have produced a loss of 25.8 per cent in a mixed portfolio of Canadian and global securities in 2008, the year of the financial crisis.
But flip that around and a portfolio of 90 per cent bonds, 10 per cent stocks would have actually generated a profit of 2.7 per cent. Such is the importance of asset allocation.
Fast forward to 2020 and we’re seeing a similar phenomenon. Despite the recent rally, all the major stock indexes are in deep in negative territory for the year thanks to the coronavirus and the resulting economic lockdown. But the FTSE Canada Universe Bond Index was up 4.77 per cent year-to-date as of April 28. The FTSE Federal Bond Index was doing even better, at 6.48 per cent.
So, the world is unfolding as it should. Except not quite.
In my last column, I mentioned an email from a reader whose bond ETF dropped seven per cent on a single day in March. That unnerved him enough to sell everything and go to cash.
It wasn’t just his ETF. The same phenomenon occurred across the whole bond ETF spectrum and revealed a hitherto little-known risk. ETFs are listed on stock exchanges and trade quickly. The underlying bonds in which they invest do not — some may go for days with no trades. The result was a mismatch: A high volume of sales orders for the ETFs was not matched on the buy side, thus pushing down prices to well below their net asset value (NAV). Market dynamics at work.
The U.S. Federal Reserve Board and, later, the Bank of Canada stepped in and stability was restored. But the March shock raised questions about whether using ETFs and/or mutual
funds to hold fixed-income securities is safe.
It’s a critical question for investors. As of the end of March, we had more than $209 billion invested in bond mutual funds and another $66 billion in bond ETFs, according to the Investment Funds Institute of Canada.
Both types of funds invest in an underlying portfolio of bonds, based on their mandate. But there are significant differences between bond ETFs and mutual funds, which you need to be aware of when deciding.
ETFs are passive investments for the most part, meaning they track the performance of a specific index, such as the FTSE Canadian Universe Bond Index. Their cost (management expense ratio) is much lower than that of a comparable mutual fund. ETFs trade on stock exchanges and can be bought or sold with a phone call or the click of a computer key.
Bond open-ended mutual funds, by contrast, tend to be actively managed. A team of experts decides on where and in what proportions the portfolio is invested, consistent with the overall mandate. That cost, plus the fees paid to sales people, makes them more expensive. A mutual fund’s NAV is determined at the end of each trading day and units are bought or sold from the fund’s treasury on the basis of that NAV. That means mutual funds are not subject to the intra-day swings in prices that bond ETFs experienced in March.
Over the longer term, any distortions in bond ETF prices should sort themselves out, although this time it took central bank action to correct a deteriorating situation. But the short-term shock, when it happens, can be unnerving and, as we’ve seen, can result in emotional investor decisions.
So, which is better to own? Over the long term, you’ll likely earn a higher return with a bond ETF because of the lower fees. But that means exposing yourself to the kind of shock we saw in March, when trading imbalances drove prices well below NAVs.
If you can’t handle that uncertainty, stick with mutual funds. Right now, those that focus on AAA-rated government securities are the best bet. Avoid high-yield and emerging market bonds. They’re being hammered in this market.
Returns on mutual funds may be a little lower than ETFs because of the fees. The tradeoff is you won’t need a sleeping pill at bedtime.
Gordon Pape, a contributing columnist for the Star’s Business ection, is editor and publisher of the Internet Wealth Builder and Income Investor newsletters. He may have personal holdings in the investments he writes about. Follow him on Twitter: @GPupdates