I managed bond mutual funds for years. This is why I think you should just buy an ETF

Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed-income and asset-mix strategy. He is a former lead manager of Royal Bank’s main bond fund.

Many investment strategists are predicting a bull market in bonds in 2023. They believe central banks will, at a minimum, stop raising interest rates this year and may even begin lowering them significantly. That implies bond prices, which move inversely to bond yields, will rise. Indeed, bond yields on long-term issues may already be peaking.

If you agree with the bulls, or just want to add to the fixed-income weights of your portfolio to reduce exposure to a risky stock market, what’s the most effective way to do so?

To start, there are two considerations. The first and most important one is costs. Investors are all too often fooled by not factoring in what these are, especially over the long run. Many investors pay too much through high fees in mutual funds.

Although an investor may be okay with paying more than 1 per cent in annual fees for a standard diversified bond fund, it is a mistake.

Let’s take a simple mathematical calculation. If one invests $100,000 over a 20-year period and bonds return 4 per cent annually before fees, that investment – assuming the interest is reinvested – will be worth $219,112. If those bonds were in a mutual fund with a 1.1-per-cent fee, the investor would be left with $177,136 – $41,976 less. That is more than 40 per cent of the original investment. If the investor had chosen an exchange-traded fund at a cost of 0.1 per cent in fees – which is typical these days – they would have $214,937 – $37,800 more.

Many bond managers in the past, and perhaps even now, insist they can achieve a significantly higher rate of return than their benchmark, fully justifying their fees.

These managers and their marketing people should know better.

Very few bond managers can achieve excess returns over a significant time period without increasing risk. Those who knock the ball out of the park one year eventually revert to the mean and fail to consistently repeat that success. Do not confuse someone who took big risks and got lucky for being skilled.

This brings us to the second consideration investors need to understand. Bond managers are usually very smart – on average a lot smarter than their equity colleagues, in my experience. They tend to be experts at math and, in some cases, engineering. They also may be less likely to allow hubris and ego to enter into their management styles.

But that doesn’t mean they are going to generate substantial excess returns.

Bonds correlate with each other more tightly than individual equities. Except for periods like the bond bear market we saw last year, bonds are far less volatile – even for riskier corporate issues – than equities. Therefore, bond managers are limited in terms of how much excess return they can derive relative to risk.

You would be a superstar among fixed-income managers by adding just 0.50 per cent in returns over a bond index over several years. That is, unless you’re cheating by loading up on risk via higher-yielding corporate and provincial bonds.

An equity fund manager who can outperform an index by 0.50 per cent in excess returns wouldn’t get the same kind of bragging rights.

It’s for these reasons that I believe ETFs are the preferred way to invest for individual investors. There are a large variety of them available. An investor can choose a market aggregate fund that attempts to replicate the returns of a broad index of various terms of bonds and leave it at that. These funds invest in Government of Canada issues, provincials and municipal bonds and domestic investment-grade credits.

Keep in mind that the bond issuance of the entire market may not correspond to the needs and risk tolerance of the individual investor. The average term of that portfolio and exposure to interest-rate movements may be too short for a Generation Z investor and too long for a baby boomer or member of the Silent Generation.

Fortunately, even a fairly novice investor can create a portfolio of a few fixed-income ETFs that are a better reflection of their investment objectives and risk tolerance. There are short-term, floating-rate and long-term funds that can be used to manage average term of a bond portfolio and therefore interest rate risk. The investor can improve their average yield by including investment-grade and high-yield corporate debt. Intrepid investors can buy foreign bond funds with or without currency hedges. Foreign sovereign funds can be exposed to industrialized nations or emerging markets. Inflation-hedged bond ETFs can be used if desired, or even levered funds that can multiply potential returns. There are even ETFs that effectively “short” interest rates, which paradoxically rise in price when rates rise and vice versa. More and more innovative products are coming to market to offer consumers better value.

What about just buying individual bonds? For most retail investors, I don’t recommend it.

I was an institutional manager so I purchased and sold bonds at very tight spreads. Individual investors, by contrast, would have had to pay much more in their trades, effectively making any purchase less cost-effective. Also, the diversification of ETFs can’t be beat. Buying just one or two individual corporate bonds, for instance, is just too risky given the potential for credit issuers defaulting.

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