Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Bond Fund Primer: Part Two – Look Before You Leap

 A Deeper Dive

Once you understand the basic terms and have narrowed down the seemingly endless choices of bond funds, it is critical to analyze your finalists before committing to a purchase. Two funds with a similar profile may actually perform quite differently depending on the type of strategy employed by the find manager. Navigating the additional risk factors is an essential component to making a solid investment choice.

Let’s say that after working through the first Bond Fund Primer, you have decided your objective is to invest in a no-load long-term government bond fund. You are worried about credit exposure, but will accept some interest-rate volatility.

A great resource for sorting through funds is Morningstar. They are a provider of independent investment research and fund screening services and have both free and premium content available. A quick search using their fund screener to find a no-load long government fund returned 26 choices. These fund characteristics are all over the place. Total fund assets ranged from $17 million to $4.5 billion, expense ratios from 0.10% to 1.75% and YTD performance is between -30.28% and +13.9%. Wow. And these are all funds with the same generic category, term and credit profile! Those ranges alone should tell you that there can be quite a large difference in how funds are managed and the impact those management choices will have on your return.

As this point, your primary goal is to eliminate all of the fund choices that do not meet your investment objectives. This will greatly simplify the process and lead you in the right direction.

The first step to take is to automatically eliminate any funds with a minimum investment above your threshold. By eliminating funds with a minimum of $100,000 or greater, I was able to bring the list down to 18 choices.

The next thing to notice as you look through the results is whether or not all of the funds represent the style you have chosen. This might seem an overly simplistic point to question, but it is quite common for a fund’s style to be misclassified. As I look through the results of my screen for a long-term government fund, I notice that all of the funds listed carry a AAA credit rating, but some own other classes of securities such as corporate bonds. (Yet another reason to do your research before investing!) They might be fine for a core bond fund, but since my specific objective is to own a government fund, we will eliminate those as well. Down to 12.

With a few funds left, you can begin to investigate the portfolio holdings and uncover additional risk factors.

Notice, I have not yet commented on basing your choice of fund on past performance. Past performance, while important, should not be one of the primary areas of focus in the initial screening process. If you begin filtering by performance, you will end up chasing funds that have already had a good run and end up underperforming the market and missing your investment objectives. We will discuss the right metrics for considering past performance below.

Understand the Portfolio
The next step is to begin evaluating each fund’s core portfolio. You should be able to find detail on a fund’s top holdings as well a breakdown of the individual securities. As you consider the portfolio holdings, first notice the fund’s cash position. My advice is always to choose funds that do not have large boluses of cash. If you wanted to leave your money in cash, you are welcome to do so without paying a management fee. When you have made the decision to invest, you want to put your money to work in the market. A cash percentage in the single-digits is alright. Anything higher than the mid-teens and you should look elsewhere.

Next, verify the bond quality meets your investing objectives. We’re looking for government securities and that should be what we find in the portfolio make-up.

Lastly, look at the fund’s top 25 holdings. Here you can gain insight into how the fund’s assets are managed. Look for asset concentration (whether only a few securities make-up the entire portfolio or it is better diversified), trading frequency, as well as the use of options and/or futures as a hedging technique. In general, investors should look for a diversified portfolio. Trading frequency and the use of options and futures is a personal choice. Personally, I don’t usually mind when managers trade the portfolio as long as they can keep their costs down and appreciate the use of risk management techniques. I figure that’s what I’m paying them to do versus buying an ETF or managing the portfolio myself! But that is an individual choice.

Now, you may look at past performance

Having begun with a universe of over 200 taxable bond funds, I was able to immediately narrow it down to 26 funds that met my investment objectives. Of those, several were misclassified or had minimums above my threshold. Looking closely at the 12 remaining funds, I was able to eliminate another third due to poor asset concentration. With the finalists, it is now the time to consider past performance, current yield, manager tenure, and expense ratios to make our final decision.

Past performance, while not a reliable measure of future returns, can add perspective on whether a manager has been able to outperform his/her benchmarks. A benchmark is the average market performance for the same category of securities and you should understand when a manager can deliver outperformance without taking on additional risk. This component is often overlooked. In bull markets, a fund manager can employ leverage or add riskier securities into the portfolio in an effort to boost performance. It might work under certain market conditions, but may also backfire considerably. Regardless, it exposes an investor to additional risk in their portfolio they may not be aware they are taking.

When considering past performance, look at a trending graph of how performance has been versus the benchmark in the last five to ten years (after fees). If you’re looking for a long-term investment, you will want to know if the manager can provide sustained outperformance versus a comparable benchmark. That’s really the extent to which past performance should drive your investment decision. Any greater study will likely lead you to chase performance or take on additional risk you didn’t intend to take.

To make your final determination, consider the bond fund’s current yield, manager tenure as well as the expense ratio. You will want to avoid funds with considerable management turnover and keep your expense ratio low. Follow-up on your choice a few times a year to make sure the core fundamentals continue to meet your investment objectives.

Conclusion

After employing this level of scrutiny, you should be able to finalize your investment decision with confidence. It may have seemed like a long road, but doing appropriate research will protect your investment and enhance your portfolio.

Using this technique, I will recommend some specific bond fund choices in my upcoming premium content.