Choosing Bond Funds Over ETFs: The Wisdom Of Safe Investing

Includes: EES, SLY, VTWO
by: Sandeep Godiyal

Even in a bad economy, there is wisdom in investing in mutual funds. For as long as investors are aware of the different instruments available to them, they can continue to build their individual investment portfolios to meet their investment goals within their time horizon. This is, of course, with the assumption that the investor has a clear financial goal in mind.

Two of the more popular mutual funds are bond funds and exchange traded funds or equity funds. There are pros and cons to investing in these funds. In every investment undertaking, you should understand the short-term and long-term risks that you are facing. These risks can easily be managed with the advice of an expert financial manager. In a volatile economy, it is often safest to stick to fixed income investments such as those offered by bond funds. Although I have other investments, the conservative investor in me has decided to put the majority of my investments in this asset class.

Understanding Bond Funds and ETFs

In bond funds, the pool of funds is invested in bonds which means that there are guaranteed yields. The valuation of the shares, however, could still fluctuate every day as the fund managers buy or sell the bonds in the mutual fund portfolio. Bond funds are considered to be safer investment instruments because of the nature of the financial products the funds are ultimately invested in. Some of those that you may want to consider would be the Federated Institutional High Yield Bond Fund ((FIHYBF)), the USAA High Income Fund (USHYX), and the Ivy High Income Fund (WHIAX).

Exchange Traded Funds or ETFs, on the other hand, are funds that are invested in equities or stocks of publicly listed companies. The net asset value per share can fluctuate drastically depending on the movement of stock values in the basket of ETFs. Depending on how hands-on you want to be as an investor, you can choose to trade in the stock market yourself or simply invest in equity funds to take advantage of the yield opportunities this financial market. Among the best performing ETFs in the small cap market for the first couple of months in 2013 are the SPDR S&P 600 Small Cap TF (NYSEARCA:SLY), the Vanguard Russell 2000 ETF (NASDAQ:VTWO), and the Wisdom Tree Small Cap Earnings Fund (NYSEARCA:EES).

Advantages of Bond Funds

The main advantage of bond funds is that it deals with fixed income instruments. I just cannot stand thinking about the possibility of losing money. I understand that any investment carries risks and that is why I tend to exercise caution in my investments. I choose to invest in bond funds because I find the volatility of ETFs to be nerve wracking. Here are some of the advantages that I found with bond funds:

  • Expert monitoring and management - You do not have to look for bonds to invest in. The fund managers of the bond fund that you choose will take care of looking for bonds where they can invest the pool of funds they are managing. Among these types of bonds that are invested in by bond funds include government or sovereign bonds, corporate bonds, municipal bonds, mortgage-backed securities, and zero coupon bonds. Your fund manager will be responsible for determining which bonds have the highest potential returns and the lowest risks.

I highly suggest looking for funds offered by fund management companies that have been around for a long time. You should be able to get a prospectus of the different funds they offer. This document contains all the information that you need about the different funds. You want to particularly take note of the past performance of the funds you are investing in. This will show you how stable or how volatile the fund's growth is on a yearly basis.

  • Liquidity - bond funds are valued at the end of each trading day. You can actually look up your fund values and decide to make a withdrawal based on the daily NAVs. You can choose to make a partial redemption or a full redemption depending on what your investment goals are. You should, however, make sure that you take note of any transaction costs and redemption fees your fund management companies might charge. If the yields on your bond funds are substantial enough to cover these fees, you can go ahead and preserve your income by redeeming your gains.

Those who want to go long term can simply leave their investment in the fund and wait for the time when the fund reaches their desired NAV. To enjoy gains as you earn them, you can withdraw any amount over your principal investment. In an account with an initial investment of $10,000, for example, you can give your fund manager instructions to prompt you for a partial withdrawal when your NAV reaches a level that brings your account value to $15,000.

  • Less volatility - if you are like me, you would appreciate the steady movement of the NAVs of bond funds. There is less volatility to worry about especially since bonds can only be transacted once a day. This is unlike stocks or equities which can be transacted several times in a day as values change. A good tip for medium- and long-term investors in mutual funds is not to watch the NAVs too often.

Your fund manager should be able to give you your regular updates to show you how your fund is performing. Financial studies show upward yields for bond funds within a period of 10 to 20 years. In a positive market, you can realize substantial gains within a year or two without having to deal with the same risks as ETFs. The ETF PowerShares S&P SmallCap Information Technology Portfolio (NASDAQ:PSCT), for example, has a 1-year yield of 8.9% as compared to the Federated Institutional High Yield Bond Fund's 11.38% over the same time frame.

Analyzing Your High Yield Bond Fund Options

You can take the conservative position by investing in any of the top performing bond funds mentioned above. Take a look at the various performance indicators of each fund. If you have room in your available disposable income, it is recommended that you choose at least a couple of these bond funds to invest in. The potential yields across the three named funds are basically similar. But if you take a look at the industries where these funds are placed, you might notice some differences.

Given the minimum initial investment requirement, the Ivy High Income Fund is the most accessible at only $500. This, however, comes with a higher expense ratio. This means that there are more fees and charges you have to consider. This includes loading fees as well as redemption charges. Over the span of 10 to 15 years, you can expect modest gains from this fund. Take advantage of the power of cost averaging by topping up on your investment or buying more shares periodically. Since the minimum investment requirements are low, this will be easy enough for you to manage.

On the upper end of the spectrum would be the Federated Institutional High Yield Bond Fund which requires at least a million dollars to invest in. Its average annual returns across all time frames are slightly higher than the two other bond funds mentioned. The fees and charges are minimal, charging you only with redemption and management fees. In terms of sector allocation, this fund is placed mostly on consumer cyclicals. This includes companies in the automotive, housing, entertainment, and retail industries. Consider industry forecasts for these industries to have a feel of how bullish yields could be for this bond fund.

The Future of Bond Funds

The prospects and general outlook for these bond funds are still quite rosy for this year as yields are expected to go upwards, beating benchmarks set by portfolio managers. Of particular note are high yield bonds and municipal bonds. Investment experts recommend investing in these instruments for modest investment profits without worrying about high risks. I would definitely recommend that new investors take a look at their investment options in bond funds. These funds are mandated to disclose the same performance and portfolio information. Take a look at their fact sheets and read the fund managers' reports. Evaluate your options carefully and make sure that they match your investment goals and yield expectations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.