The Logic of Bond ETFs

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.