Investors Miss Out on Great Bond Rally
By Ron DeLegge
September 8, 2010
SAN DIEGO (ETFguide.com) – If there’s one thing investors are good at it’s being in the wrong place at the right time. Evidence of this reoccurring trend is readily visible in the bond market, whose bullish run continues.
As bond yields have dropped, bond prices have soared. But instead of participating in the Great Bond Rally most investors are a day late and a dollar short. Why?
Let’s analyze the reasons.
The 2008 Credit Crisis should’ve taught people that Wall Street is the last place they should trust when it comes to managing their valuables. Too much leverage and too much overconfidence by corporate leaders steering places like Bear Stearns, Lehman Brothers, etc. contributed directly to the meltdown. The once prized stocks and bonds of these celebrated financial institutions disintegrated.
Fearing the worst, people piled into government bond funds which turned out to be the best performing investment category in 2008. How did it turn out for them?
Over the past three years, Standard & Poor’s data shows an overwhelming majority of active government bond funds have fared horribly compared to brainless bond index funds and ETFs. For professionally managed long-term government bond funds, 89.22% failed to beat corresponding indexes and a whopping 93.26% of all short-term government bond funds lost compared to their matching yardsticks.
The translation is fairly simple: Since the onset of the recession and the Credit Crisis, mutual fund managers have done a lousy job in managing risk and getting performance.
Hitting a Home Run with a Lob
What if mutual fund managers and their shareholders were handed a bull market of epic proportions? Would they profit or would they mess it up? One way to know is by looking at the bullish performance of junk bonds, politely referred to as “high yield debt” in investment banking circles.
After being pummeled by around 25% in 2008, junk bonds (NYSEArca: HYG) have become one of the hottest investment categories anywhere. In 2009 they jumped by roughly 40% and so far this year they’re up another 6% to 7%.
But instead of joining the party, investors in junk bond funds have been left in the cold. Just over 80% of all professionally managed junk bond mutual funds have underperformed junk bond indexes during the past year alone and almost 95% duplicated the same embarrassing results over the past five years. Meanwhile, through thick and thin, the typical investor in an actively managed junk bond mutual fund has gotten plenty of nothing.
Going Tax Free
Municipal bonds, also known as “munis,” are debt obligations issued by states and local government to finance various projects and services for the benefit of their communities. Since the enactment of the Federal Income Tax Amendment in 1913, municipal bonds have enjoyed tax exemption from the Internal Revenue Code.
As a result, munis have become popular investments, especially among high income earners looking for tax-free income. For instance, a resident of New York City that buys a New York municipal bond receives income that is free from federal, New York City and New York state income taxes. Good as that may sound, investors have been perfecting their mistakes by aligning their money in the wrong places.
Professionally managed munibond funds in the two largest states, California and New York, have performed awfully over the past five years. Standard & Poor’s found that just over 97% of all actively managed California and New York munibond funds underperformed versus S&P AMT-Free Municipal Bond Indices. To add insult to injury, most of these lousy performing actively managed munibond funds have annual expenses that are quadruple the cost of matching munibond index funds and ETFs.
The message is clear: Owning actively managed munibond funds has been and probably will continue to be a losing strategy. For a better alternative, look at low cost munibond ETFs like the iShares S&P New York Municipal Bond Fund (NYSEArca: NYF) and SPDR Nuveen Barclays Capital California Municipal Bond ETF (NYSEArca: CXA). According to ETFguide.com’s ETF database, the average expense ratio for U.S. municipal bond ETFs is 0.26% and both of the above mentioned ETFs are in that general range.
One argument typically used in favor of actively managed bond funds over bond index funds is that money managers can increase their exposure to cash when the market goes haywire in order to reduce market volatility and potential losses. Unfortunately, this wonderfully cute theory hasn’t worked out. Even though bond index funds and ETFs must always remain fully invested, it’s hardly proven to be a disadvantage.
The Great Bond Rally teaches us the typical bond fund investor continues to strike out. While they definitely can’t buy a hit during a bear market, even during a massive bull market they can’t seem to win. Why? Because the masses have yet to learn what index investors already know; trust the indexes not the portfolio managers that try to beat them and fail.