Many investors don’t pay much attention to the bond portion of their portfolio. And that’s not surprising. Bond funds aren’t very exciting. I suspect most investors’ reasoning goes something like this:
- If I pick a winning stock fund, my results improve dramatically.
- If I pick a winning bond fund, my results improve by what, one percent per year?
And they’re right. But they’re overlooking two important facts:
- A 1% improvement in performance leads to a big difference in portfolio value after a few decades, and
- It’s easy to pick a winning bond fund–much easier than picking a winning stock fund actually.
How should you choose a bond fund?
Of course, sticking with low-cost index funds and ETFs is a great strategy for the stock portion of your portfolio as well. But it works even better when picking bond funds.
If you look at the Standard and Poors Index vs. Active Scorecard from prior years, you’ll see that in most years, somewhere between 30-40% of stock funds outperform their index. In contrast, it’s typical for less than 20% of bond funds to outperform their index.
Why is it so hard for bond funds to beat their index?
- Costs consume a higher portion of bond fund returns than stock fund returns, and
- There’s little room for bond fund managers to exercise their skill in ways that allow them to gain extra performance.
For example, if the stock market earns an 8% annual return over a given decade, a stock fund manager would have to outperform the market by one eighth (12.5%) on a pre-cost basis in order to overcome a 1% annual expense ratio.
In contrast, if the bond market earns a 5% annual return over a given decade, a bond fund manager would have to outperform the market by 20% on a pre-cost basis in order to overcome a 1% annual expense ratio. That’s a much higher hurdle to clear.
Making matters more difficult for the manager of an active bond fund is the fact that there’s little he can do to earn above-market returns. Managers of stock funds can exercise their skill by picking and choosing between thousands of different stocks. Managers of bond funds, however, are typically restricted to investing in a very narrow category of securities–U.S. Treasury debt with maturities of 3-5 years, for instance.
In short: It’s difficult for a stock fund manager to overcome a 1% annual handicap from costs, but it’s darned near impossible for a bond manager to overcome a 1% annual handicap. Your best bet is to stick with the lowest-cost fund you can find that owns the type(s) of bonds you want in your portfolio.
Published or updated July 6, 2010.