"One of the troublesome things about fixed income investing is the reinvestment of interest income. It comes in small, inconvenient amounts that tend to reduce your rate of compounding. The best way to eliminate this annoyance is to buy fixed income mutual funds." (From "Do You Really Need a Bond Fund?)
I am trying to calculate this for myself based on the following assumptions:
• A $50,000 Fixed Income Investment to be allocated toward a five-year Treasury Ladder in a SEP-Ira account with Vanguard Brokerage Service account.
• The alternative is the investment with annual expenses of a Vanguard Short (or Intermediate) Term Treasury Bond Fund (.27% per year).
I have 20 years to retirement. How exactly would one quantify the return lost (due to the reduction in compounding) versus the additional expenses of the bond fund?
---M.S., by e-mail
A. There are two kinds of investors in this world, those who are accumulating money and those who use their accumulated money to pay their bills. The mathematics of their investing is very different.
Whether you invest in a mutual fund or hold a ladder of individual securities, the reinvestment of investment income poses the same problem--- your true return will depend on interest rates prevailing each time you have some interest to reinvest. The difference is that the mutual fund provides a vehicle for automatic reinvestment, on a timely basis, of very small amounts of money.
For that reason, a low cost fund is the ideal vehicle for accumulation. In your case the cost of the Vanguard fund would be $135 a year. You can calculate the cost difference by considering that the fund investment immediately reinvests all income at the prevailing return of the fund while investment income placed in a money market fund would yield much less.
With the $50,000 Treasury ladder the interest income will be held in a money market account until enough is accumulated to buy an additional Treasury security. Since the yield on money market funds is lower than the yield on longer-term securities, you'll be "losing" interest.
How much interest you "lose" while waiting in the money market fund and the cost of investing in new Treasury obligations determines the exact break-even point for accumulators. Assuming a 2-percentage point difference on $2,000 a year (The annual income of a $50,000 portfolio earning 4 percent.) the cost of holding individual securities would be the lower interest in a money market fund--- about $40 a year--- plus the expense of at least one purchase per year, about $50. That's a total expense of about $90 a year. That's $45 less than the cost of the mutual fund.
To me, the convenience of automatic reinvestment is worth more than the $45 difference--- so I'd stay with the mutual fund for accumulation until the portfolio is larger.
Things change when your portfolio is in distribution. The reinvestment problem disappears because you are taking the interest and spending it.
Then there is only one meaningful question: Does the cost of managing a fund reduce the net return so much the investor would be better off in a simple, but direct, investment, such as a 5-year Treasury?
I have been examining that question for ten years. The finding, updated regularly, is that a simple 5-year Treasury note will provide you with more money to spend and less investment risk than an index of major government securities funds. This tells me that most fixed income funds aren't worth their management expenses.
The operative word here, however, is "most."
If you visit my website you can see more than 5 years of monthly studies. You can see which funds do well and which do poorly. As you might expect, a few funds do better than the 5-year Treasury--- and a few funds do very poorly.
Three funds are at the top of the list: Vanguard GNMA, Fidelity Government Income, and American Century GNMA. Accumulating or distributing, they're good fixed income choices. All three are no-load funds with relatively low expense ratios.
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