From the July 2007 issue of Wealth Manager Web • Subscribe!

ETFs Get Bonded

Here's a news flash: Your clients are getting older! That certainly may be stating the obvious, but it's an obvious statement that has wide-ranging implications for your business. With age comes changing investment objectives: More income, less risk. All of which means a greater allocation to fixed-income investments. Fortunately, you have some new options.

For the most part, your two options have been individual bonds and bond mutual funds. The former is tough for you to use. For starters, not all clients have enough money to build a truly diversified portfolio of individual bonds. Also, commissions and fees on bonds have historically been as transparent as concrete. And besides, your expertise really isn't the bond market, so for you to pick a basket of individual bonds is probably not the best way for you to be adding value. Thus, you have used mutual funds to cover your client's fixed-income needs. That has worked well, for the most part. But just as your business on the equity fund side has been morphing toward exchange-traded funds--you love the tradability, transparency, and low expenses--you are wondering if you should be doing more fixed-income ETFs.

The problem, though, has been limited choice. Prior to 2007, only six fixed-income ETFs were available--all from Barclays via its iShares brand. However, the ETF world is like Denver's weather--if you don't like it now, wait 10 minutes. Indeed, an additional 14 fixed-income ETFs have been added this year, and several more--including some actively managed fixed-income ETFs--are waiting in the wings. The bottom line is that advisors now have many more choices to achieve fixed-income exposure via ETFs.

But the word hasn't gotten out yet. While the growth of ETFs has probably caused many sleepless nights for the heads of mutual fund firms, ETFs have made few inroads in the fixed-income world. At the end of April, only $23 billion was invested in fixed-income ETFs-- just 5 percent of all ETF assets. However, the increased number of choices may change the percentage.

The table below provides a list of all bond ETFs. Notice that only two firms--Barclays and Vanguard--currently play in the bond ETF sandbox. These ETFs cover a host of style boxes, including short-term, intermediate-term, and long-term bonds; investment grade and high-yield funds, mortgage-backed bonds and treasuries; and inflation-protection bonds. Notable areas where fixed-income ETFs have yet to stake a claim include municipals, international and emerging markets. But don't fret; I expect these holes will be filled over the next 24 months--especially the hot international sector--once ETF providers can figure out how to handle some of the operational and liquidity issues in these particular markets.

With all these choices, advisors can easily take advantage of fixed-income ETFs, which have individual bonds and bond mutual funds beat in several areas:

o Liquidity-Bond ETFs, which can be bought and sold intraday, offer greater liquidity than individual bonds or mutual funds.

o Greater flexibility for "macro" bets-Let's say you are bearish on interest rates. With ETFs, you now have an easy way to make a bearish bet on rates by selling short a particular bond fund. Also, bond ETFs make it easier to create a long/short portfolio in order to play changes in credit spreads.

o No investment minimums-You can invest as much or as little in ETFs as you like. Individual bonds and bond mutual funds typically have minimums.

o Lower annual expenses-As the table shows, all but one of the bond ETFs has annual expenses in the range of 0.11 percent to 0.20 percent. And the exception--the high-yield offering from Barclays--has an annual expense ratio of 0.50 percent, well below the category average for high-yield mutual funds of 1.24 percent, according to Morningstar.

Still, it's not a slam dunk that bond ETFs are superior to bond mutual funds in every situation. Indeed, if your clients need muni or international bond exposure, mutual funds or individual bonds are your only choices. Also, while bond ETFs have lower annual expen-ses, on average, relative to bond mutual funds, the cost advantage may be much smaller or even disappear when you take into account the commissions paid to purchase ETFs.

For example, Vanguard recently entered the bond ETF market with four new funds. One of the ETFs mimics Vanguard's Total Bond Market mutual fund. Interestingly, the annual expense ratio on the mutual fund is 0.20 percent versus 0.11 percent on the Vanguard Total Bond Market ETF. At first blush, buying the ETF over the mutual fund seems a no-brainer, right? The two are virtually identical in their investments, yet one is cheaper than the other. But depending on the amount of money you are investing, the frequency of investments and your holding periods, that cost advantage could disappear or even swing in favor of the mutual fund. That's because you'll pay a brokerage commission every time you buy the ETF while you won't pay any sales fee when buying Vanguard's mutual fund. The commission you pay to buy the ETF can make a big difference in the total costs of ownership.

Let's say you invest $10,000 in the Vanguard Total Bond Market ETF (BND). Your annual expense on the fund is 0.11 percent, or just $11. The annual expense for the mutual fund is 0.20 percent, or $20. But if you pay a commission to buy the ETF that exceeds $9, it's more costly to buy the ETF, at least in the first year. In year 2, however, if you don't buy any more of the ETF, the cost advantage swings back to the ETF. But if you are making frequent investments in the ETF, you could spend $100 or more (if buying on a monthly basis) in commissions. Such frequent purchases may require you to reconsider the open-end mutual fund.

Of course, you can run a variety of scenarios where the ETF, over time, has a big cost advantage. Furthermore, your client may not mind paying a few bucks more per year for the ability to buy and sell the ETF intraday. Trading costs do matter. But my guess is that trading costs alone--unless you are making very frequent purchases with very small amounts--will not justify picking a bond mutual fund over a bond ETF in the same style box.

A more compelling argument in the fund-versus-ETF controversy comes down to the following question: Can active bond management add more value than simply indexing bond investments? One school of thought says that active bond managers, as a group, do a better job of adding value than their equity counterparts. That's because the bond market, so the argument goes, is less efficient than the equity market. Our research shows that over the last five years, nearly 30 percent of fixed-income managers in the intermediate-term bond space outperformed the Lehman Brothers Aggregate Bond Index. And over the last 10 years, roughly 15 percent have outperformed. So yes, it is possible to find index-beating bond managers, which may give some advisors pause when considering bond ETFs. But look at those statistics again: If 30 percent are beating their benchmarks, seven out of 10 are not. And if just 15 percent of bond managers are winning over the last 10 years, what are your chances of finding that one-in-seven manager? Therefore, while I don't discard the notion that it is possible for advisors to pick active bond managers who can beat the indices, I would offer that it is no easy task.

If you buy that bond ETFs make sense for client portfolios, the next question is, which ones? Again, only Vanguard and Barclays offer bond ETFs, and both have a history of good returns in the fixed-income market. Furthermore, you may find only one bond ETF covering a certain style box. But in those areas where Barclays and Vanguard compete head-on, here are some things to consider:

o Expenses-Academic research shows that a huge driver of bond fund performance is the expense ratio. All things being equal, a lower expense ratio is better than a higher expense ratio when looking at similar ETFs.

o Tracking error to the index-Obviously, the best bond ETFs are those with the smallest tracking error relative to the underlying index. How funds attempt to mimic their index will influence tracking error. Some funds use a sampling approach, buying a subset of the securities in a particular index to replicate the index. Other funds buy all of the securities in the index. You would expect the latter approach to track the index a bit better over time.

A good head-to-head comparison is the iShares Lehman Brothers Aggregate (AGG) versus Vanguard Total Bond Market (BND). Both ETFs mimic the same index--the Lehman Brothers Aggregate Bond Index. This index attempts to track the entire bond market. Which ETF is the better choice?

o On the expense front, iShares ETF charges 0.20 percent versus 0.11 percent for Vanguard: Advantage Vanguard.

o iShares uses a sampling approach to indexing (the iShares ETF holds less than 200 securities); Vanguard's ETF has much broader coverage of the index with nearly 2,200 securities. While the iShares ETF has done a nice job of tracking the index, you would expect Vanguard's ETF, over time, to have lower tracking error. Advantage, once again, to Vanguard.

o When it comes to performance, Vanguard still holds the edge. If you compare the iShares ETF with Vanguard's Total Bond Market (VBMFX) mutual fund over the last three years (and remember, the Vanguard mutual fund has a higher expense ratio than the similar Vanguard ETF at 0.20 percent versus 0.11 percent), Vanguard has outperformed the iShares ETF by around 0.15 percent per year. While that may not seem like a lot, in an environment of low interest rates, 15 basis points per year is rather meaningful.

Bottom line: Make sure you consider Vanguard's offerings along side Barclays, if bond ETFs are on your radar screen. And they certainly should be.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.

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