How Bond ETFs Lower Your Returns and Hurt Asset Allocation

Hardly a day goes by without a story about how ETFs are revolutionizing the investment world.  There are now many articles and posts praising bond ETFs, but what's been missing from the analysis is the often underwhelming returns these investments deliver and how they can actually hurt your asset allocation.

Let’s first tackle returns.

The $49 billion iShares Core US Aggregate Bond ETF (AGG) was up 2.76% through July 31, a fraction of what investors could have earned had they invested in a select number of individual corporate bonds. To compare, through July 31, my portfolio of individual corporate bonds has returned 8.9% and 7.5% for investment-grade and high-yield corporate bonds, respectively (see detailed calculations here). Since AGG is so big, it has to be overweighted in lower-yielding Treasurys, agencies, and mortgages since it can’t buy higher-yielding corporate bonds in $100 million clips. On August 4, it wasn’t until AGG’s 232nd-largest holding that you found a corporate bond.

This year-to-date underperformance relative to owning individual corporate bonds was seen across iShares' leading ETFs, as shown in the following table, which compares my corporate bond investment returns to those of the leading iShares ETFs: