According to the Investment Company Institute, assets in taxable bond funds totaled $573 billion in March. With an average annual expense ratio of 1.11 percent this means the industry takes in about $6.3 billion in fees to manage a menagerie of nearly 2,200 funds.
Too bad most people would do better by investing directly in 5-year Treasury notes.
There are two reasons for this.
The first was cited in my Sunday column. For 100 five-year investing periods, a 5-year Treasury note has beaten a representative index of government securities funds 86 percent of the time. To do that, it has had to beat most of the funds in each of the 100 time periods. Since the maturity of the 5-year note starts at 5 years and runs down to zero while the average government fund has a maturity of nearly 9 years, the T-Note always has less interest rate risk than a fund.
But what about emerging markets bond funds? What about high yield bond funds? What about short, intermediate, and long term corporate bond funds? What about multi-sector funds? Surely there is some area where bond managers thrive and deliver superior results.
The primary purpose of bond funds is to provide sustenance for the firm that sponsors them. They may seem clever. They may be experts in convexity and duration. They may be able to quote Sidney Homer the way others quote the Greek of the same name or Homer Simpson on MTV. They may have seriously computerized offices. But when push comes to shove, the odds are we would be better off in a 5 year T-Note.
In the 5 year period ending March 31, the average 5 year load adjusted annualized return on the universe of 2,199 taxable funds was 5.59 percent. Only 435 of the taxable funds did as well as, or better than, a 5 year Treasury note.
That's less than 20 percent of all taxable bond funds, meaning that you had one chance in five of picking a fund that would do better than a Treasury note and you had to be willing to invest in risky borrowers or for long time periods to do it.
If we simply ask that the fund have an average maturity of 5 years or less, so the time risk is no greater than the Treasury note, our list of winning funds goes down to 38.
Yes, you read that right.
In a period of declining interest rates, only 17 of every thousand taxable funds beat a 5-year Treasury. Those aren't very good odds.
So what do we do?
If you are an accumulator, still needing to reinvest your interest income, you do it as simply and inexpensively as possible. That means no front-end load funds. No deferred load funds. No funds with big 12b-1 fees. It means investing domestically and not letting the management company scarf up your return. It means putting more of that $6.2 billion in fees in your pocket, not theirs.
If you are retired, however, it means investing in 5-Year Treasury notes. You can create a perpetual "ladder" of 5-year Treasury notes in three years. This means you will have a note maturing each year and that your average maturity will be about 2.5 years. Both your principal and your flow of income will be less vulnerable than the typical fixed income mutual fund.
How do you make a Ladder of 5-year Treasury notes?
Simple. To build a $50,000 ladder you buy one 5 year Treasury, three 2 year Treasuries, and one 1 year Treasury. At the end of one year, you buy a new 5-year Treasury with the maturing one year note. You'll then have notes maturing in 5, 4, and 1 year. At the end of the second year, you buy a new 5-year Treasury with the maturing one year. You also buy a 2-year note and a 1-year note.
In year three and thereafter, you replace a single maturing note with a new 5-year note. Your ladder is complete.
How do you buy Treasury obligations?
In a taxable account, buy directly from the government through Treasury Direct. You can learn how on the web at http://www.publicdebt.treas.gov/sec/sectrdir.htm The Treasury has put together a very complete and informative website on Treasury investing.
In a qualified account the easiest route is through a self-directed brokerage account. Treasuries can be purchased at auction through Vanguard Brokerage Services for $25; the fee is $50 at Fidelity and $49 at Schwab. This means your management cost is down to 0.2 percent if you invest $13,000 in T notes at Vanguard, $25,000 at Schwab or Fidelity. Invest more and your "expense ratio" will drop in proportion.
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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