Bond fund management is not known for clever and novel ideas– at least, not well known. Active management with aggressive timing of maturities and different credits, option-writing, other uses of derivatives–all seemingly offered the potential for improved returns or yields with limited risk. Some delivered. Some flailed. Some failed.

Enter the exchange-traded fund (ETF) concept. While ETFs have been around for almost a decade, growing remarkably popular over the last three years, the first bond ETFs emerged this summer (July 26, 2002, to be precise). As advisors, we need to ask some very basic questions. Are they just the latest bond gimmick? If they’re so great, why the delayed introduction? And why pay a brokerage commission on an ETF bond index investment, when good no-load bond mutual funds abound?

Some analysts have pooh-poohed the concept of a bond ETF, because the ETF’s ability to minimize capital gains distributions is not as important for a bond fund as for a stock fund. (Most bond return comes as income, not capital gains, which must be distributed whether held in an ETF or a mutual fund, although bond funds can realize gains when interest rates are falling.) But the ETF’s structure has other advantages; minimizing fund expenses and trading costs are actually more important for bonds than for stocks.

How to Get Higher Returns

Apart from working to minimize taxes (e.g., by maximizing 401(k) contributions or buying municipal bonds), there are three basic ways to get higher returns in your income portfolio:

1) Go long. Usually the yield curve is positive, meaning long-term rates are higher than short-term. (The opposite situation, short rates higher than long, is what is known as an inverted yield curve.) One can pick up yield by moving from a money market fund to short-term bonds, then to intermediate- or long-term bonds. Risk also goes up with each step. When interest rates rise, long-term bonds lose the most. (Typically, a bond with 10-year maturity has a duration of seven, meaning if rates climb one percentage point, it will lose 7% in value.)

2) Take on credit risk. High-quality corporate bonds have higher yields than U.S. Treasuries; lower-quality corporates have even higher yields, with junk bonds (those rated below BBB) yielding the most. The lower a bond’s quality, the higher the issue-specific risk of company default and the loss of some or all value. One can reduce issue-specific risk with a diversified portfolio and good fund management, but junk bonds, just like stocks, always have broader risks of falling collectively in a downturn. That said, investment-grade corporates always yield more than Treasuries; a well-constructed portfolio of investment grades should beat a comparable Treasury portfolio over time with little or no added portfolio risk.

3) Lower investment expenses. This is the only free lunch. Money you don’t pay your fund company is money you keep, risk-free.

Should fund expenses always be considered “lost money?” No. Active management has a place in junk bond portfolios and emerging markets bond portfolios, just as it has in portfolios of stocks, especially illiquid, inefficiently priced stocks. Where securities from different companies show varying returns and prices are inefficient, a manager can pick the overlooked and undervalued; some managers have shown solid records of long-term outperformance.

But for more efficient markets, especially Treasury bonds where credit issues don’t come into play, but also for larger, high-quality corporate bond issues, active management adds little, and can’t make up for correspondingly higher expense ratios compared to index investing.

Why Index?

If you pick a bond fund now from among all taxable funds, based on past performance for, say, five years, you’ll be led to the longest-term bond funds, most of which are invested in Treasuries or high-quality corporates. That’s because long-term interest rates have been dropping during this period, so we’ve been in a bond bull market–especially good for the bonds most sensitive to rates. Of course, this is also the area that will get hit the hardest if longer-term rates climb back.

The recent historical advantage of longest-term bond funds has less to do with fund management skills than with fund objectives. And as an advisor, you can’t really judge relative performances of two or more funds without limiting comparison to those with similar maturities and credit qualities. For higher-quality bonds with similar maturities and credit qualities, most return variation is due to differences in fund expenses. So the investment-grade (and government) domestic bond market calls for low-cost index investing.

The iShares ETF

Enter the exchange-traded fund, or ETF, the newest and fastest-growing part of the fund universe. The Barclays/iShares GS $ InvesTop Corporate Bond Fund (LQD) is the first U.S. corporate bond ETF. It seeks results corresponding to the performance of the U.S. investment-grade corporate bond market as defined by the Goldman Sachs InvesTop Index.

The LQD, just launched on July 26, already had $1.6 billion in assets by early September. To judge a manager or a novel concept, we hope for more of a track record than that. But this fund’s two key features, index investing and a low-expense ETF structure, are tried and true.

The LQD is an investment-grade index bond fund with an average credit quality of A, but somewhat more in BBB securities than AA. It owns a “representative sampling” of 100 different bond holdings from 60 corporate issuers; it recently had 98.5% of assets in these 100 bonds. Recently, LQD had a weighted average maturity of 10.4 years and a duration of 6.4.

The index’s investment-grade bonds are chosen in consideration of several factors, most notably sector diversification, at least a $500 million value, proven liquidity, and being less than five years old with at least three years until maturity. Since bonds do mature, there is continuous turnover, unlike stock ETFs. The ETF is well diversified, with the largest position just 1.1% of the fund. Unlike most equity index funds, which are market-cap weighted, it is about equally weighted by par value. Being bonds, the portions shouldn’t get as skewed by market action as they would in a stock fund.

Shares aren’t guaranteed to trade at net asset value (NAV, the per-share value of the underlying bonds), but institutional creation and redemption of ETF shares means deviations should remain miniscule.

Other ETF Options

Three other bond ETFs, all tracking Lehman Brothers Treasury-only indexes, are offered by Barclays/iShares: Lehman 1-3 Year Treasury Bond Fund (SHY), Lehman 7-10 Year Treasury Bond Fund (IEF), and the Lehman 20+ Year Treasury Bond Fund (TLT). See www.ishares.com for more info.

Barclays also plans to introduce the iShares Lehman Treasury Bond Fund, iShares Lehman Government/Credit Bond Fund, and iShares Lehman Credit Bond Fund (no dates yet set). And Nuveen Investments plans four Fixed Income Trust Receipts, or FITRs, covering Treasuries with one-, two-, five-, and ten-year maturities. (Nuveen already has an ETF holding investment-grade taxable preferred securities, the Nuveen Quality Preferred Income Fund.)

Why Cheap Is Good

What’s so appealing about the Barclays/iShares GS $ InvesTop Corporate Bond Fund? It’s cheap. It’s an index fund; almost nothing else matters. Its annual expense ratio is a rock-bottom 0.15%. The average expense ratio even for bond index mutual funds is almost 0.40%; for managed bond funds it now exceeds 1.00%. You can do better than the averages, with the lowest usually Vanguard (bond fund expenses of just 0.20% to 0.25%), but they’re still not quite as cheap as this ETF.

While Vanguard (and Fidelity, etc.) bond funds have no sales loads, many multi-class bond funds do charge front-end loads or redemption fees. That may be fine for a junk bond fund with solid management, but for yield investors in higher-quality bonds it means “going hungry” for nearly a year. In comparison, the ETF’s stock-like commission schedule is minimal. A $25 commission on a $25,000 investment comes to 0.10%. With a round trip and 0.3% bid/ask spread, the total transaction cost should be about 0.5%. Thus, for holding periods of under about four years, a fund from Vanguard (but practically no other) would be marginally cheaper than the LQD ETF, despite the ETF’s lower expense ratio. For longer periods, or where the alternate fund has more typical expenses, the ETF is the cost–and thus likely the performance–champ.

One final consideration: an ETF’s lower bond turnover and lack of shareholder redemptions should mean that the fund itself is paying less in trading costs such as bid/ask spreads than are many actively managed funds, and even index funds whose shareholders are doing considerable buying and selling.