Investing PART 13: Mutual funds (contd.)

Bond funds: But don’t form a lasting bond.

Bond funds present even more problems the stock funds. With a managed bond fund, at a minimum, one is betting that the fund manager can forecast (i.e., guess) the direction of rate changes. Further, the manager will then use that guess to achieve performance that is relatively good compared to his or her benchmark. That benchmark may have nothing to do with why you own the fund.

If the fund isn’t restricted to a particular type of bond (e.g., government, corporate, prime, high yield, etc.), one is also betting on the managers’ ability to anticipate and capitalize on changes in spreads (i.e., the differences in rates on different types of bonds). If it’s an international bond fund, it often contains currency risks based on the value of the holders’ currency verses every other currency in the portfolio. If the manager tries to hedge out the currency risk, the hedge itself introduces its own risks (i.e., performance, liquidity, counterparty).

Overlay on that bundle of risks the main issue which is the analysis of the financials of the institution issuing the bonds in the portfolio. Given all the considerations, it isn’t too surprising that many bond funds just skipped doing the financial analysis and relied on ratings. But, bond fund fees are often significant. One has to wonder how the fees were spent if not for analyses of the investments being made.

However, the most important thing to remember about bond funds is that they fluctuate in value. Many advisors recommend adding bond funds to a portfolio in order to get more stability in the value of the portfolio. The important point is that their objective is to add volatility in the value of individual assets that offsets the cycles in stocks. The logic is based on modern portfolio theory (MPT). MPT implies that two volatile assets that fluctuate in different patterns, one going up when the other is going down, will produce a better return than a single more stable asset. It’s all very logical if one accepts the basic thesis that more volatile assets have better returns. The historical evidence is that it seems to be true. The historical exceptions are so narrowly defined that they are considered more the exceptions that prove the rule than a cause to question the usefulness of MPT. Since the historical data is the input into the analysis used to develop the theory (i.e., MPT) that isn’t too surprising.
There are three things to dislike about an approach that relies on bond funds. First, it is very hard to find a bond fund that makes money after inflation “through-the-cycle.” Most, bond funds have major downturns at various points in the business cycle. If held for long periods of time (through the default cycle and the interest rate cycle), they just barely earn more than inflation or lose real value. Note that the logic of adding them to a portfolio depends on rebalancing, a crude form of timing.

The second thing to dislike is that as an asset class bond funds are often presented as stable. They are NOT stable. Prices and yields fluctuate. They fluctuate because bond prices, interest rates, and default rates all fluctuate. Further, they aren’t CDs. Bonds in the fund are traded. The bonds in the fund have the same trading risk as stocks as well as greater liquidity risk than broadly-traded common stocks.

The last reason to dislike bond funds concerns substitutes. It is just too easy for an average Joe to buy better alternatives. A group of bonds organized so that maturities coincide with life events reduce uncertainty vary efficiently. Value at target dates is known, current market price is known, yield is known, and if the intent is to hold the bonds, yield to maturity is known. With a bond fund market price is known and current yield is known. In exchange for knowing future yield and future price, one gets liquidity, fees and a bond trader.

From what has been said you probably figured out that The Hedged Economist is not a fan of either general stock funds or almost any bond fund. That covers a lot of territory. There are other ways to segment the mutual fund industry. They’re the topic of a future posting.