The Superiority of Bond Funds

Includes: JNK, LQD, TLT
by: Erik Gholtoghian

Do you ever reach a point where you are just tired of stocks? Have you ever wondered if there are investments which return more and have less risk of losing money? Are there asset classes which outperform in terms of risk-adjusted returns?

The Coefficient of Variation is a great statistic to test the answers to these questions. It takes the standard deviation (variability) of the returns and divides by the returns of the fund to create a number which averages to equal your bang for your buck.

To find out if there are better investments than stocks, I decided to test the recent 3 year CV ratio from most major asset classes using commonly traded ETFs.

I tested the following ETFs:

TLT (high duration treasuries)
LQD (high grade corporate bonds)
JNK (junk bonds)
GLD (gold)
SPY (large cap US stocks)
IWM (small cap US stocks)
ADRE (emerging market stocks).

The results are below. The lower the number, the more bang for your buck - the lower amount of risk and higher amount of return, the fund has shown:

* denotes a fixed income fund

ETF CV Return/Week SD
GLD 10.6 0.30% 3.12%
LQD* 13 0.11% 1.49%
JNK* 17.8 0.18% 3.23%
IWM 27.4 0.16% 4.51%
TLT* 37.9 0.06% 2.23%
ADRE 43.6 0.12% 5.21%
SPY 66 0.06% 3.73%
Click to enlarge

Clearly, GLD has had the best risk adjusted return, but this may be explained by a dramatic and unusual bull market for gold over the past 10 years. Even with this giant bull run in gold, and a huge financial crisis which hurt corporate bond returns, high grade corporate bonds have still performed nearly as well as gold in terms of risk adjusted return, although with much lower return. Throughout history, fixed income has tended to have better than average CV ratios because of the regular cash flows provided. Because of these cash flows, it is more difficult to really lose a ton of money in bonds. And in some cases, bonds can still have a great return, such as JNK.

For example, JNK had three times the return of the S&P500 with lower risk. LQD also had almost double the return and had less than half the risk of SPY, and even 20 year government bonds ((NYSEARCA:TLT)) earned the same return as the SPY, yet with much lower risk. Of course, this could be explained on the horrible return the stock markets have had over the past three years, but investors should always be prepared for the worst, yet still earn good returns.

Because the average investor really doesn't hold for more than three years, most investors really shouldn't be buying stocks. The last three years have been the perfect example. Over the long term you will generally earn high rates of return by holding stocks, but what most investors don't know is that it takes decades for this expected return to materialize. True, stocks can rise even in a short period of time, but when the standard deviation of stocks is considered, the reality is that you will not earn money buying stocks unless you hold for at least three years. Looking at the Nikkei Japanese stock index shows that stocks can go decades with negative returns.

Even though investing in only one major asset class is not very diversified and can result in portfolio problems, by just using a single bond ETF, most investors could improve their portfolios dramatically. Commissions and management fees can be reduced while still earning a stock market beating risk-adjusted return. And because you are investing in a bond ETF, you are still diversified across many, many bonds.

So, in conclusion, the next time you gamble your last $2500 by buying some stock, hoping and praying it will rise quickly so you can sell for a quick profit, think about Japan and the fact that capital gains take decades to materialize. Instead, buy an asset with a lower CV ratio such as JNK, LQD or another corporate bond fund. You just might find yourself making money instead of losing it.

Disclosure: I am long JNK.