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By John Gabriel

Upon reflecting on the 2008 credit crisis, many investors might've realized that they were too concentrated in equities and that a balanced portfolio of stocks and bonds could have mitigated their downside considerably. Sure, most asset classes plunged in the back half of 2008 amid the global deleveraging crisis. However, lest we forget, in a monumental "flight to safety" we saw a rally of epic proportions in U.S. Treasuries.

We hope that most of the $35 billion in new assets that flowed into fixed-income exchange-traded funds in 2009 were not just chasing performance. But, considering what we know about general investor behavior, it's probably not too far off to conclude that fear and panicked buying also likely helped fuel the massive inflows into bond ETFs and mutual funds last year. (In 2009, fixed-income funds accounted for $357 billion of the $377 billion in total net inflows into open-end mutual funds). Over the course of the year many ETF providers also rolled out new products to match the growing demand for bond funds.

Now, as the lurking risks of bond investments make headlines, some are speculating that flows could slosh back out of bond ETFs and mutual funds in search of higher returns elsewhere. In our view, rather than trying to time the market, investors would be much better off in the long run by thinking about their fixed-income exposures as part of a long-term asset-allocation strategy.

Along these lines, Gluskin Sheff economist David Rosenberg argues that the current divergence between flows into equity and fixed-income funds could persist for some time because of what he calls a "secular change in behavior." In a Dec. 1, 2009, report, Rosenberg cited that less than 7% of household assets were in bonds, 25% were in equities, and 30% were in real estate. With aging demographics serving as a tail wind, he believes that investors could continue shifting assets into bonds, further propelling the divergence in flows between stocks and bonds. To be clear, we offer Rosenberg's point-of-view solely as food for thought.

In any case, the huge flows into bond funds also lead us to think about the differences between owning a bond fund and owning individual fixed-income securities. Of course, investors who are just temporarily parking assets in the bond market should find that ETFs' superior liquidity makes them the preferable vehicle. The stickier assets that flocked to bonds with asset allocation and long-term investing goals in mind, however, should be aware of the pros and cons between owning a bond versus owning a bond ETF.

Consider this: When an ETF invests in stocks, those stocks retain their equity market characteristics. However, a passive bond index ETF is a much different animal than say, owning any one of its underlying bonds individually. Bonds in an ETF no longer look or act like bonds. Simply put, bonds have maturity dates, whereas indexed bond investments do not. Remember, the interest-rate risk of an individual bond will decrease as it approaches maturity. A bond ETF, on the other hand, exhibits constant interest-rate risk. With interest-rate risk at the top of mind, this can be a critical point to consider for investors.

An example might help drive this point home. It is common practice for many to invest in laddered bond portfolios designed with specific maturities. This makes a ton of sense for those planning for a major event (such as a child's college education) and who plan to hold until expiration and collect par on their investment (this is commonly referred to as a liability driven investment). Price swings caused by movements in interest rates might be of little concern to such investors who know they'll receive par on their investment at maturity, as long as the creditor remains solvent.

Although the ETF research team can sometimes have a bias toward the ETF structure, we openly concede that there are investment scenarios that often favor other structures. As we've previously suggested in Morningstar ETFInvestor, we think that, in many cases, bond ETFs are most suitable as complementary players in an investor's bond allocation, perhaps between 10% and 30% of the total bond allocation. The remaining fixed-income allocation, for instance, could be a laddered portfolio of individual bonds with specifically tailored maturities designed to offset a given individual's future liabilities.

To conceptualize a bond or bond ETF's sensitivity to a movement in interest rates, investors should refer to a metric called modified average duration. For example, if interest rates were to instantaneously rise by 1%, a bond ETF with a duration of 10 years would be expected to see a corresponding 10% price haircut. The drop in price of the bond compensates for the fact that newer bond issuances will be available at higher yields following an interest-rate hike.

Again, it's important to make the distinction between investors seeking a short-term place to park cash and those using bond ETFs as part of a long-term asset-allocation strategy. We would discourage long-term-minded investors from trying to time the market by tinkering with their fixed-income allocations. With an investment horizon of more than five years or so, investors would still do fine holding on to their bond ETFs.

The reason is that the underlying index will adjust over time in order to maintain its target maturity. As a bond ETF's portfolio reconstitutes, it will rotate into higher-yielding issues (of similar maturities) as they become available. Thus, after an initial hit early on, the total return profile of the bond ETF should gradually improve as more of the equivalent, but higher-yielding securities steadily make up a growing portion of assets.

Hence, most investors would surely be better off by simply maintaining discipline and enduring an initial bump in the road. Market-timing strategies are notoriously difficult to pull off--at least with any sort of consistency. Plus, the transaction costs incurred would act as an additional head wind for those seeking to time their fixed-income investments. Instead of engaging in market-timing or performance-chasing practices, we think long-term-minded investors should use near-term market dislocations as rebalancing opportunities.

It will be interesting to see how demand for bond ETFs holds up as we move through 2010. We probably won't see the fear-driven spike in inflows that helped propel asset growth in 2009 repeat itself this year. However, if Rosenberg's thesis rings true, then demand from long-term-oriented asset allocators could end up being enough to continue driving net inflows into bond ETFs going forward.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Individual Bonds vs. Bond ETFs: Two Completely Different Animals