A recent poll of ETF investors found that other than low fees, good performance history is taking prominence as a prime consideration in fund selection. That undoubtedly means extra work for advisors, who must redouble their know-your-product efforts to go beyond the cheapest offerings in finding what’s right for their clients.
But even an increased focus on returns is not enough, especially with regards to bond ETFs. In a recent column for ETF.com, Wealth Logic LLC Founder Allan Roth shared why he would recommend certain bond ETFs to clients — even if the funds are among the worst performers in their field.
“Sometimes clients are puzzled that I recommend bond ETFs such as the iShares Core U.S. Aggregate Bond ETF (AGG) or the Vanguard Total Bond Market ETF (BND),” Roth said. Citing Morningstar data as of February 6, he noted that the two funds were outdone by 79% of and 77% of their peer group over the past decade.
“Thus, these are bottom-quartile funds over 10 years—and those percentages might even be worse after correcting for survivorship bias,” he said.
He explained that the two bond ETFs follow close cousins of the Bloomberg Barclays U.S. Aggregate Bond Index, which is designed to track the investment-grade, US dollar-denominated, fixed-rate, taxable bond market. In other words, the two ETFs are index-based, and their underperformance would naturally suggest that indexing doesn’t work for bonds.
Roth noted that the peer group used by Morningstar in comparisons is composed of high-quality, moderate-duration bond funds. While the two ETFs certainly belong in that category, he explained that the peer group takes on much more credit risk than the ETFs that follow the index.
While AGG has 64% exposure to US government-backed bonds, the peer group averages only 45%. In addition, AGG is 73% AAA-rated, in contrast to the 40% average exposure of the peer group. As for junk-bond exposure, AGG has 0% against the nearly 6% average for the peer group.
“The purpose of bond ETFs is to be the portfolio’s shock absorber,” Roth noted. “You want your bonds to do well when stocks tank. The more credit risk a bond fund takes, the more it behaves like a stock fund.”
To drive home the point, Roth rewound to 2008, when AGG gained 7.9% amid the stock plunge; in contrast, the peer group lost 4.7%, and the junk space shed an average of 26.4%. After the subsequent 10-year bull run, US stocks sustained a modest loss in 2018 as the total return for the S&P, including dividends, lost 4.38%. Even with that small dip, AGG outperformed by gaining 0.1% against an average peer-group loss of 0.5%.
“The bottom line is that you want your bonds to behave differently than stocks. You want to be able to use your bonds to rebalance and buy more equities,” he said. “In fact, I believe that rebalancing boosts returns.”
Warning investors not to believe claims that bond indexing doesn’t work, he noted that the raging bull market of the past 10 years is unlikely to persist for another 10. He recommended a portfolio that takes risks with equities that are balanced with a fixed-income portfolio of high-quality bonds and certificates of deposit.
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