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Bonds: Why Bother?

A great article from Rob Arnott in the Journal of Indexes May/June issue. It is fairly lengthy, so I just pasted the conclusion below. In a nutshell, bonds are generally--and incorrectly-- underloved by the investment community. I've added this article to my 'interesting article vault' at the very bottom right of my blog (a high honor!):
 

Conclusion

We manage assets in an equity-centric world. In the pages of the Wall Street Journal, Financial Times and other financial presses, we see endless comparisons of the best equity funds, value funds, growth funds, large-cap funds, mid-cap funds, small-cap funds, international equity funds, sector funds, international regional funds and so forth. Balanced funds get some grudging acknowledgment. Bond funds are treated almost as the dull cousin, hidden in the attic.

This is no indictment of the financial press. They deliver the information that their readers demand, and bonds are—at first blush—less interesting. The same holds true for 401(k) offerings, which are overwhelmingly equity-centric. If 80–90 percent of the offerings provided to our employees are equity market strategies, is it any surprise that 80–90 percent of their assets are invested in stocks? And is it any surprise that they now feel angry and misled?

Many cherished myths drive our industry’s equity-centric worldview. The events of 2008 are shining a spotlight, for professionals and retail investors alike, on the folly of relying on false dogma.

  • For the long-term investor, stocks are supposed to add 5 percent per year over bonds. They don’t. Indeed, for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market.
  • For the long-term investor, stock markets are supposed to give us steady gains, interrupted by periodic bear markets and occasional jolts like 1987 or 2008. The opposite—long periods of disappointment, interrupted by some wonderful gains—appears to be more accurate.
  • For the long-term investor, mainstream bonds are supposed to reduce our risk and provide useful diversification, which can improve our long-term risk-adjusted returns. While they clearly reduce our risk, there are far more powerful ways to achieve true diversification—and many of them are out-of-mainstream segments of the bond market.
  • Capitalization weighting is supposed to be the best way to construct a portfolio, whether for stocks or for bonds. The historical evidence is pretty solidly to the contrary.

 

As investors become increasingly aware that the conventional wisdom of modern investing is largely myth and urban legend, there will be growing demand for new ideas, and for more choices.

Why are there so many equity market mutual funds, diving into the smallest niche of the world’s stock markets, and so few specialty bond products, commodity products or other alternative market products? Today, investors are still reeling from the devastation of 2008, and the bleak equity results of this entire decade. They have already begun to notice that there were opportunities to earn gains, sometimes handsome gains, in a whole panoply of markets in the past decade—most of which are still difficult for the retail investor to access.

We’re in the early stages of a revolution in the index community, now fast extending into the bond arena. In the pages of this special issue of the Journal of Indexes, we see several elements of that revolution. In the months and years ahead, we will see the division between active and passive management become ever more blurred. We will see the introduction of innovative new products. The spectrum of bond and alternative product for the retail investor will quickly expand. We will shake off our overreliance on dogma. And our industry will be healthier for it.