Questioning The Value of Bond ETFs

by: The Sun posted on: May 10, 2007 | about stocks: AGG / BIV / BLV / BND / BSV / IEI / SHY / TLH    
Morningstar recently had an article cautioning investors on bond ETFs. With the recent introduction of four Vanguard bond ETFs, it can be expected that investors will look into these new ETF offerings when building their portfolios. However, the article, Think Twice Before Investing in Bond ETFs by Paul Herbert, reminds investors that there are a couple of factors we should consider before jumping on the bond ETF bandwagon - my summary:

First, are bond ETFs bringing any benefits on the cost of owning them?

ETFs are generally cheap as compared to their mutual fund counterparts and bonds ETFs are no exception. However, given that bond mutual funds themselves already have very low expense ratio, the advantage of bond ETFs on fees over bond mutual funds may not be as obvious as that between equity ETFs and mutual funds. For example, as the article points out, Vanguard Total Bond Market Index [VBMFX] has an ER of 0.20%. The Vanguard bond ETFs, on the other hand, charge 0.11% in fees. The difference could become a non-factor when ETFs' trading cost is added.

Second, does bond ETFs offer tax advantage?

Another selling point of ETFs is that they are more tax-friendly than mutual funds because “mutual fund redemptions may force a fund manager to sell securities at a gain to raise cash, but ETF sales occur on the exchange and don’t force a manager to do anything,” and the inactivity will effectively limit capital gain distributions. Yet for bond ETFs in particular, the tax advantage isn’t that obvious, since bond mutual funds distribute very little in capital gains.

Finally, are active bond ETFs better than bond index ETFs?

Unlike in the equity fund world where active fund managers had hard time beating index funds over the long run, there are a number of active bond fund managers who have produced consistently superior returns for bond investors. As the article shows, as of March 31, 2007, “38 out of 331 distinct funds in the intermediate-term bond-fund category have produced 10-year returns that top the Aggregate Bond Index’s gain.” Thus, investing in passive bond ETFs may not give investors the returns they are looking for as compared to investing in actively managed bond mutual funds, even in the long term.

After making the above arguments, the article concludes that

All in all, we still think there can be a place for ETFs — and most other cheap, tax-efficient funds — in investors’ portfolios. And truly sophisticated investors may get some benefits from trading ETFs intraday or short-selling them. But given the strengths of traditional bond mutual funds, we continue to think that they serve most investors very well.

In summary, three key benefits, costs, taxes, and returns, that equity ETFs have enjoyed aren’t very appealing when it comes to investing in bond ETFs.

This article has 4 comments! Add yours below...
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This article has 4 comments:

  •  
    esweb
    May 10 10:56 AM
    I'm no financial professional, but doesn't this mean that ~90% of distinct funds did NOT produce higher 10-year-gains?! And, don't we also need to define "top" a little more? It could mean 0.000001% for all we know.

    From what I recall, roughly 80% of managers can't beat the S&P 500. That would indicate that the stock pickers are MORE successful than the intermediate-term bond-fund category pickers. No?

    I'm a small investor looking to add to my bond holdings, easily. It would still seem that AGG or BND still make sense for this purpose. No minimum purchase and I can get in or out whenever I choose.

    Thoughts?
  •  
    Johnny
    Bitchdog
    May 14 10:50 PM
    Good questions.

    Morningstar's cautionary statements do not look like good, objective information.

    Look's like a corrupt and deceptive attempt to aid actively managed bond funds.

    If the author had made some kind of argument that, on average, actively managed funds did beat the passive index by more than the .10 percent expense savings, it might have been valuable.

    the simple fact is that the actively managed bond funds may underperform or outperform and the investor takes that risk. just because a small percent of managers have good long term records does not address the proper question.

    Morningstar wants as much complexity as possible so they can sell their b.s., while not pissing off any major customers........take what they say with a grain of salt.

    it does look like the ETF benefits are stronger for equity funds, but bond funds seem advantageous as well.

    also, there is cash drag for traditional mutual funds which must stand ready to meet redemptions.

    looks like Morninstar b.s. or incompetent analysis to me.
    john.
  •  
    Nathan Smith
    May 29 11:25 PM
    John,

    If you'd bothered to read the full (albeit) Morningstar article, you'd see that their article is very objective. More so than your own statements may I add?. The value of the article (and Morningstar overall) IS its objectivity. Anyways, besides the active vs. passive argument (no clear winner), tax implications and costs (think commissions) are touched on.

    I'm calling you out on b.s. and incompetent analysis.

    Nate
  •  
    lemming
    Jun 23 02:37 PM
    Nathan,
    you sound like a real winner, so I guess Ill listen to you and not John, should I buy morningstar or a bond fund?

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