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Why we use individual bonds vs bond mutual funds

One important note to distinguish us at Ables, Iannone, Moore & Associates from other firms is we use individual stocks and bonds.  This helps us manage portfolios with tremendous flexibility, control and transparency.  It also allows us to reduce costs.  We believe this makes it easier to align our management to the goals of the client vs a one size fits all feel that is associated with model portfolios and financial products.

The other week I wrote a post about some of the opportunities we are seeing in the fixed income space in current market conditions.  I won’t rehash that discussion but it largely centered on individual bond structures we like in a rising rate environment. 

http://www.aimainc.com/blog/entry/how-can-i-put-money-to-work-in-these-market-conditions-1-2

What you may have noticed is it did not include bond mutual funds or ETF’s for that matter.  Here are 3 reasons why:

  1. The mechanics of a traditional bond mutual fund make it impossible to guarantee your return of principal because you don’t own the actual bonds in the fund, you own proportional shares of the mutual fund’s net asset value (NAV). More importantly, there is no maturity date established in a traditional bond fund.  This is because they are pooled investment vehicles in which thousands of investors aggregate their money together with a manager who is charged with following the investment goals of the fund in perpetuity as outlined in the prospectus.  Therefore, when an investor wants to redeem their money they do so at the NAV of the fund at the end of that given day.  In response to this, fund sponsors developed mutual funds and ETFs that have a defined maturity (DMF).  These products do offer a close approximation to a return of principal in the form of a final investment value but may still fall short of actual principal return due to costs and other factors in running the fund.  Further research shows that DMFs can produce more volatility than traditional funds due to their structure and carry higher costs which can drag on overall performance.  Contrast this with owning bonds outright.  Minus an issuer default or another agreed upon structure to the bond, the investor gets their principal back at maturity regardless of the fluctuating value of the bond during the holding period.
  1. It’s hard to actually get fixed income out of them because of the numerous variables in determining the yield of the fund. It is beyond the scope of this post to dive into all the factors that determine bond fund yields but suffice it to say, it can get complicated.  However, it is important to understand that distribution yields are calculated on a per-share basis, typically dividing the most recent per-share distribution by the current per-share net-asset value (think share price of the fund).  That means if either of these inputs change it will result in a fluctuating distribution yield (think payout to you as shareholder).  And it will change because new bonds are constantly being added, cash is constantly moving in and out of the fund, prices of existing bonds will change and the manager is under pressure to maintain a competitive yield in order to attract new investors.  Is your head spinning yet?  You’re not alone.  Years ago, the Securities and Exchange Commission stepped in to mandate a standardized yield calculation, called the 30-day SEC yield, largely in response to the fact managers were manipulating their fund’s stated yield to appear more attractive than it actually paid out.
  1. They seem expensive when factoring in all the fees and expenses. Many investors miss or don’t understand the true cost of ownership which may include commissions, 12b-1 fees, soft dollar arrangements, transaction and brokerage costs, tax implications and annual expense ratios.  Depending on the fund, these costs can range between 2% - 4% per year.  This would be in addition to whatever you may be paying your finanical advisor. 

http://www.aimainc.com/blog/entry/the-real-cost-of-owning-a-mutual-fund

Let’s recap.  There is no guarantee made as to the return of principal.  It’s hard to nail down the cash flow that will be generated from owning shares of the fund.  And they are expensive.  So why use them?  First and foremost they are easy to own.  It makes getting diversified exposure to fixed income really simple.  Also, there are times in which no alternative exists such as inside a company 401k or other retirement plan.  On the more nefarious side, advisors can be incentivited for selling or using the funds in client portfolios.  We see this quite a bit with the big name places – looking through a statement and seeing the firm’s own funds conveniently being used.  I digress. 

Our goal isn’t to rail against bond mutual funds or ETFs and it’s not to suggest you are going to investment hell for using them.  Rather, it is to highlight the alternative of using individual bonds to customize specific fixed income solutions.  Instead of pooling that money with thousands of other investors under one goal of a fund manager, we find it is superior using individual bonds to manage various risks such as duration, reinvestment, interest rate, principal and credit for our clients.  It provides flexibility and clarity on what you own, how much cash flow will be generated and an end date for when we can expect a return of principal.

 

Ables, Iannone, Moore & Associates, Inc. is a fee-only, SEC  registered investment advisory firm providing asset-management to clients in over 20 U.S. states, Europe, Asia and South Africa.  We have over 50 years of combined experience in the financial services industry.

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