The Logic of Bond ETFs

Searching for Alpha, the monthly index newsletter for December 2006

There are a ton of reasons why equity exchange-traded funds (ETFs) are one of the fastest-growing investment vehicles. Cost is the most often-cited benefit. ETFs like the S&P Depository Receipts (SPY) boasts an annual expense ratio of 0.10%, a fraction of the 1.50% that the average actively-managed large-cap fund charges. The nearly impossible task of beating the market means that stock ETFs are almost always better performers as well. ETFs have rewarded long-term shareholders with virtually no capital gains exposure, to boot.

Bond ETFs are another story. Although they're cheap to own, there are a number of open-ended mutual funds that are actually less expensive to own than, say, the Lehman Aggregate (AGG) or the iShares Lehman 7-10 yr Treasury ETF (IEF). Interest payments and short-term gains associated with bond investing put traditional bond funds and ETFs on much more level playing ground as well.

But the argument against bond ETFs comes full-circle when one considers performance. In the ten-year period ending in 1997, none of the actively managed intermediate bond funds outpaced the Lehman Aggregate Bond Index. In the next ten-year period, less than 10% of the funds were able to outgun the index.

The odds of an investor finding just the right active fund are so low it's not worth the effort. The energy is better spent on figuring out the right asset allocation, which ends up being a much more important decision in long-term wealth creation.

The Monthly Index Report for December 2006

Index

Nov-06

QTD

YTD

Description
S&P 500 Index*

1.65%

4.85%

12.20%

Large-cap stocks
DJIA*

1.17%

4.65%

14.03%

Large-cap stocks
Nasdaq Comp.*

2.75%

7.67%

10.27%

Large-cap tech stocks
Russell 1000 Growth

1.98%

5.57%

8.71%

Large-cap growth stocks
Russell 1000 Value

2.28%

5.62%

19.56%

Large-cap value stocks
Russell 2000 Growth

2.39%

9.02%

13.62%

Small-cap growth stocks
Russell 2000 Value

2.85%

8.09%

22.41%

Small-cap value stocks
EAFE

3.02%

7.04%

22.99%

Europe, Australasia & Far East Index
Lehman Aggregate

1.16%

1.83%

5.94%

U.S. Government Bonds
Lehman High Yield

1.68%

3.06%

11.58%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

1.49%

3.09% 2.14% Managed Futures
3-month Treasury Bill

4.44%

All returns are estimates as of November 30, 2006. *Return numbers do not include dividends. ** Returns are estimates as of November 29, 2006.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.

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