Welcome to the ETF Prime Podcast

A Better Mousetrap for Fixed Income

Most investors and advisors who have come to use and appreciate ETFs would agree that the case for ETFs relative to actively-managed mutual funds in the equity arena is firmly established, crystal-clear and completely unambiguous.  But what about in the fixed income domain?

Relative to their equity counterparts, can fixed income ETFs boast of advantages nearly so compelling in the areas of holdings transparency, breadth of systematic coverage of asset classes, consistency of coverage (i.e., lack of style drift and related concentration migration risks), low cost, tax efficiency and trading flexibility (for risk management purposes)?  And are active fixed income mutual fund managers nearly so incapable of consistently outperforming their generic, passive index benchmarks?  The answers, really not surprisingly, are Yes, Yes, Yes, Yes, Yes, Yes, Yes and a very, very big (huge) YES!

“Oh, but there are such important inefficiencies and a lack of price discovery in bond markets that active management and security selection surely must add alpha,” according to the familiar refrain from active fixed-income managers and their legions of marketing and sales specialists.

But is that active managers’ holy grail known as alpha delivered in the real world?  How about if we just cut to the chase and take a look at the world’s largest actively-managed fixed income mutual fund and its corresponding index benchmark?

Let’s  look at the world’s largest actively managed bond mutual fund – PIMCO’s Total Return Bond Fund. with roughly $120 billion in assets across its slate of share classes. The fund earned a 5-Star Morningstar rank overall as well as for 3, 5 and 10 year performance in the intermediate-term bond category.  That 5-Star ranking implies that the fund was in the top 10% within a group of peers falling under the Intermediate-Term Bond Fund classification.  And let’s look also at two ETFs covering the Barclays Aggregate Bond Index – the index identified as Total Return Bond Fund’s “benchmark”.

PTRAX and AGG

PTRAX and BND

Overall, it looks like the world’s largest actively managed bond fund, representing the top ranking 10% of such funds, is basically neck-and-neck with ETFs based on the fund’s passive benchmark index … Morningstar one-year (2008) data show that the PIMCO fund beat the two ETFs on a pre-tax basis by 65-92 basis points but underperformed on an after-tax basis by 51-72 basis points.  On a 5-year basis, PTRAX beat AGG on a pre-tax basis and by 92 basis points on an after-tax-basis.  And, again, that’s part of the top 10% of the Intermediate-Term Bond fund class.  So, going forward, how likely is the Total Return Bond Fund to eek out a long-term positive performance spread to its passive index counterparts?  Whether an investor in the Total Return Bond Fund or another of the 900+ actively managed mutual funds in the space, looking and hoping to fall into that “superior” 10% group, you simply have to ask your self, “Do I feel lucky today?”

American Funds Raising Fees

I referenced an article last month from the Motley Fool [link to post] that discussed the possibility that mutual fund fees would go up in 2009.  Despite the market meltdown of 2008 and the exodus of assets out of equity funds, American Funds has made the somewhat predictable decision that they need to raise their fees so they can, in their words, “maintain our ability to serve fund shareholders in the best way possible”.  Hmmmm.  In case you’re wondering, here are the 2008 returns for some of the largest mutual funds in the American Funds family – these are all ‘A’ shares:

Fundamental Investor:  -39.7%
Growth Fund of America:   -39.1%
Income Fund of America:  -28.9%
Investment Company of America:  -34.7%
New World:  -46.3%
Smallcap World:  -49.4%

See more information here.

Control Your Emotions…Or Get Help!

The quote I referenced recently from John Galbraith is a reminder of how much emotions play into investing.  You can have a perfectly designed asset allocation strategy and the best low cost investment vehicles available, but if you don’t stick to a plan, your returns will be abysmal.  Unfortunately, that happens more often than not with most investors.

The market research firm Dalbar recently did a study on the returns of retail investors and found that most investors end up jumping into ‘hot’ funds at the end of bull markets and then get burned when the market drops.   Their results were actually pretty amazing.  They found that over the 20-year period ending December 31, 2007, the average equity investor earned 4.48% annually, compared to the 11.81% return of the S&P 500 index.  The annual return of the average equity investor was actually barely above the annual inflation rate during the same period.  Fear and greed are tough habits to shake.

My own investing experiences, including a jump into internet stocks in the bubble of the 1990’s and my subsequent ride down to zero in some cases (I have a great story about selling Qualcomm and putting the proceeds into Globalstar) taught me that I was my portfolio’s own worst enemy.  That realization lead me initially to look for a financial advisor and, ultimately, to start The ETF Store.

If you can stay objective and unemotional with your investments, congratulations; you are the exception.  If you think you’ve sabotaged your performance or you can relate to my own experience, you might want to think about calling an advisor.

Fidelity Customers – Are You Diversified?

One of the beautiful things about ETFs is you can access an asset class or a broad market index and know exactly what you own – – without any overlap in holdings.  You can easily construct a portfolio that gives you precise and systematic coverage of all desired asset classes.  Not so with mutual funds.  Because funds are only required to report holdings quarterly or semi-annually to the SEC, it is nearly impossible at any point in time to known what you own, or know whether your desired allocations are in place.

It’s common for people to hold a number of mutual funds from the same fund family.  It’s also common for each of the mutual fund managers within that fund family to use the same group of analysts to determine what stocks to buy.  As a result, managers of different funds will end up owning the same stocks, even though the investment objectives laid out in their prospectuses may be quite different.

While fund overlap is an issue at many fund companies, my sense is that it might be a bigger issue at the larger ones.  So I asked the software Company Overlap [www.overlap.com] to calculate the amount of overlap for a group of Fidelity Funds.  The output is below.

Pretty interesting stuff.  If you own a few of the funds in the graph, you might wonder why you have a basket of funds that own a lot of the same stocks.  One major caveat to the graph though – this is based on the most recent holdings information provided to the SEC.  Since the funds don’t report their holdings very often (and those are on a delayed basis) I have no idea what the overlaps would be today!