NorthWest Quadrant Bond Funds - No Bond ETF Has Done As Well As The U.S. Aggregate Bond Index

 |  Includes: AGG, BND, BNDS, CSJ, IEF, LQD, TLT
by: Richard Shaw

Continuing our study of NorthWest Quadrant securities, we examined mutual funds and ETFs to identify those that outperformed the benchmark U.S. Aggregate Bond Index as represented by the Vanguard Total Bond Market Index mutual fund.

There are 7 mutual funds that met our criteria and produced NorthWest Quadrant winners -- funds that had lower volatility and higher return than the benchmark fund. However, there were no bond ETFs that beat the benchmark.

The Vanguard ETF class of the U.S. Aggregate Bond Index (NYSEARCA:BND) did not even match the performance of the mutual fund share class of the same portfolio that we used as the benchmark (VBMFX). Even though the ETF has a lower expense ratio than the mutual fund share class, it produced a lower 3-year total return and a higher 3-year volatility.

click image to enlarge

Click to enlarge

Because bond ETFs have short operating histories, we were only able to compare them to the benchmark on a 3-year basis, whereas with mutual funds, we were able to require that NorthWest Quadrant funds outperform the benchmark over 3 years, 5 years and 10 years.

The table image shows the Vanguard ETF share class and mutual fund share class side-by-side (shaded gray). Because they are both share classes of he same bond portfolio, and because BND has an 11 basis point expense ratio advantage, we conclude that the premiums and discounts to NAV that ETFs experience accounts for the performance difference (mutual funds trade only at NAV).

For illustration, we listed 7 bond ETFs with their attributes. Those 7 funds were chosen arbitrarily, but there was no bond ETF that had a higher 3-year return and a lower 3-year volatility than the benchmark index fund.

The scatter diagram plots the volatility on the horizontal axis, and the mean return on the vertical axis. The two intersect at the 3-year volatility and mean return of the benchmark fund.

If a hypothetical equal weighted portfolio of the NorthWest Quadrant funds were created, that portfolio today would have this composite mix of underlying bonds according to the Morningstar fixed income style boxes:

The bonds are of high and medium quality (not low quality) and of limited and moderate duration (not long duration). While low quality bonds had a wonderful pop after the 2008 crash, over the long pull, when both return and volatility are concerned, long duration and low quality bonds underperformed.

Because long duration and low quality bonds are more volatile, they are not particularly suitable for that part of the portfolio that may be expected to be sold to generate cash to meet living requirements in retirement.

The hypothetical equal weighted portfolio underperformed the benchmark in 16 if 40 quarters over 10 years, but only underperformed by more than 1% in 3 of those periods, and only underperformed by more than 1/2% in 8 of the 40 quarters.

The histogram plots the difference in total return by quarter for the hypothetical portfolio and the benchmark fund.

Looking at best and worst periods of performance and trailing yield, we see a pretty tight picture, but a fairly uninspiring yield (basically negative real yield before taxes are considered -- one reason bonds are more attractive to tax exempt organizations than ordinary income taxable individuals).

The worst rolling 3-month return for the hypothetical portfolio was negative 1.64% and the worst rolling 3-year period was positive 2.15%. The best rolling 1-year period was positive 14.47%.

In a prior article, we identified 12 NorthWest Quadrant equity ETFs versus the S&P 500; and in another article, we identified 28 NorthWest Quadrant individual stocks versus the S&P 500.

Disclosure: QVM has long positions in LQD and CSJ in some accounts, and does not have positions in any other mentioned security as of the creation date of this article (January 5, 2012).

Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.