July 6, 2020: Bond ETFs vs. Bond Mutual Funds | Better Financial Future -- MyPlanIQ

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Monday August 3, 2020.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Bond ETFs vs. Bond Mutual Funds

The market gyration in March this year offers a good opportunity to stress test various instruments such as ETFs and mutual funds. In this newsletter, we take a closer look at how bond ETFs behaved.

Broad-based stock index ETFs

The good news is that most broad-based stock index ETFs did withstood the volatile period in March and had no large discrepancies compared with their mutual fund counterparts. For example, the following chart shows each broad-based index ETF matched its mutual fund counterpart pretty well, even in the lows of March this year:

ETFs vs. Mutual Funds (as of 7/2/2020):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR
VTI (Vanguard Total Stock Market ETF)	-2.5%	6.4%	10.4%
VTSMX (Vanguard Total Stock Mkt Idx Inv)	-2.5%	6.4%	10.4%
VNQ (Vanguard REIT ETF)	-12.2%	-6.6%	3.2%
VGSIX (Vanguard REIT Index Inv)	-12.3%	-6.6%	3.0%
VB (Vanguard Small-Cap ETF)	-11.4%	-5.7%	4.1%
NAESX (Vanguard Small Cap Index Inv)	-11.4%	-5.8%	3.9%
VWO (Vanguard FTSE Emerging Markets ETF)	-7.0%	-1.6%	3.0%
VEIEX (Vanguard Emerging Mkts Stock Idx)	-7.1%	-1.7%	2.9%

Interested readers can compare each pair individually through this link >>>

Notice that in the above, even a narrower sector REITs ETF (VNQ) still matched its mutual fund counterpart VGSIX well.

In general, mutual funds are priced using end of day prices and their NAVs (Net Asset Values) are decided by their underlying holdings’ closing prices. Their NAVs are more stable than ETFs’s prices as these are traded continuously in an exchange during market hours.

Because of ample liquidities among stocks (especially from reasonably sized small caps up), stock ETFs didn’t exhibit large discrepancies against their mutual fund counterparts.

During the last three serious market routs (2000 internet bubble, 2008 financial bubble and the recent Covid scare), other than some brief intro-day glitch, broad-based index stock ETFs have matched well.

Bond ETFs

Unfortunately, the same can’t be said to bond ETFs. Let’s look at the following charts:

The first is to compare investment grade corporate bonds ETF with its mutual fund counterpart:

VCIT’s 17% of drawdown during March is way worse than VFICX’s 9.2% drawdown. Though it recovered back somewhat in April mostly because of the Federal Reserve’s unprecedented intervention in bond markets, this is something beyond most bond and conservative investors’ risk comfort zone.

The next chart compares PIMCO’s total return bond ETF (BOND) with PIMCO’s total return bond fund (PTTAX):

We see similar larger drop of ETF BOND than mutual fund PTTAX. The maximum drawdown 11% vs. 8% is narrower but still very noticeable. Up till now, the ETF hasn’t caught up with the mutual fund.

The next one is between DoubleLine’s total return bond ETF (BOND) and its mutual fund DLTNX:

This time, the discrepancy narrowed considerably: 7.3% vs. 7.5% in terms of maximum drawdown in March. However, we attributed such narrower discrepancy to the more stable underlying holdings the DoubleLine funds had in March: DoubleLine funds held large amount of mortgage backed securities that held up relatively well during the downturn, compared with corporate bonds held by BOND or VCIT.

Finally, let’s take a look at HYD’s discount history (i.e. compared with its NAVs):

Source: Van Eck

So HYD’s price was discounted as much as 28% in March this year!

On the other hand, broad-based bond index ETFs like BND or AGG have smaller drawdown spread (8.7% vs. 6.5%) compared with their mutual fund counterparts:

In bond markets, Treasury bonds are the most liquid and thus Treasury bond ETFs have the least price discount/premium against their NAVs. A broad-based bond index ETF such as BND has a sizable weight in Treasury bonds, thus it also tends to have smaller price/NAV discount. Investment grade corporate bonds, on the other hand, are less liquid than Treasuries while high yield bonds are the least liquid and thus tend to have the largest price/NAV discounts in a volatile market.

To summarize, the above data show that

Broad-based stock index ETFs can be a very good alternative to their mutual fund counterparts in terms of volatility. In addition, they are low cost, available in all brokerages and are flexible to trade. In our opinion, investors can safely use them in place of mutual funds.
Bond ETFs, unfortunately, are really not up to the task to replace their mutual fund counterparts. This issue is more inherent and fundamental — the underlying bonds just don’t have enough liquidity for market makers and operators to quickly arbitrage away or suppress the large discounts (or premiums). We have watched this space for a long time. At the moment, we believe investors should still choose bond mutual funds if this is possible.

The implication of the above observations on our asset allocation portfolios is that one probably should use a mix of stock ETFs and bond mutual funds in a portfolio. One issue arises from this is that ETF trades are settled 2 days later (T+2) while mutual funds are settled one day later (T+1). If one wants to sell ETFs and buy a bond mutual fund, it has to wait one more day before the ETF sell is settled, instead of just simply using mutual fund exchange feature to issue buy and sell orders in the same time. Similarly selling a mutual fund and buying a stock ETF also need to wait till next day for the fund to settle. Note in a margin account, one can issue an ETF buy order the same day after placing a mutual fund sell order that will be carried out at the end of that day. Since stock trades are more sensitive to timing, in both cases (sell stock ETFs and buy bond mutual funds or sell mutual funds and buy stock ETFs) in a margin account, stock ETF trades can be carried out timely while bond mutual fund trades are delayed (which is less sensitive to timing).

This issue can be alleviated if one carefully segregates stock investments from bond investments, either in two accounts physically or in two conceptual parts in a single account. In the stock portion (or portfolio), it uses bond ETFs when it’s necessary (i.e. if TAA or AAC calls for switching from stocks to bonds). The only time when the two portions need to cross over is when the portfolio needs to rebalance among stocks and bonds. In general, we don’t recommend frequent stock and bond rebalances. One should rebalance only when there is a significant out-balance of the two portions. On average, once a year or so. Such a rebalance does not need to be in a hurry and can be carried out in more than one days.

Market overview

Even in a seasonally unfavorable period, stocks continued to rise, ignoring the bad news in Covid19 pandemic. Investors were encouraged by the ‘good’ news in June’s unemployment report: the US unemployment rate fell to 11.1% as the economy added a record 4.8 million jobs. Though headline stock market indexes such as S&P 500 and Nasdaq composites are now above their long term 200 days moving averages, clearly showing they are in an up trend, other indexes including small cap, mid cap and even the so called safe sector utilities are still meandering under their long term moving averages.

Regarding market and economic conditions, we strongly suggest readers to listen to the recent DoubleLine’s Jeffrey Gundlach’s Yahoo interview. His down to earth observations, backed by data, usually offer good and useful insights. In the interview, he brought up several points we made in the past.

Regardless, we emphasize the following in the current situations:

For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

For more detailed current market trends, please refer to 360° Market Overview.

In terms of investments, stocks are somewhat cheaper. Investors should not be swayed by the current market volatility and economic distress, instead, they should stand ready to take advantage of the opportunities. For most Americans, we offer the following Winston Churchill’s remark made in the darkest days of World War II: “The Americans will always do the right thing, but only after they have tried everything else.” As a country, the US (and the rest of the world) will get over this, as always, even after stumbles. The past development has been very supportive to our optimistic long term view so far.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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