How Bond ETFs Lower Your Returns and Hurt Asset Allocation

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:


 
In addition to underperforming a select portfolio of corporate bonds, large ETFs such as AGG hurt investor asset allocation. On August 4, AGG’s largest holding was cash -- by a mile. It had $5.5 billion of cash, or 11.3% of its total portfolio. This over-allocates investor portfolios to cash since a portion of investor money that was supposed to be invested in bonds is now stuck under the mattress. Suppose an investor has 10% cash in her portfolio and invests the other 90% in AGG. Since 11.3% of AGG is in cash, the amount of cash in her portfolio is now 20%.  

A forgettable investor outcome.  

This isn’t a problem only with the AGG ETF, but many other so-called “bond funds” and ETFs, some of which can hold up to 20% in equities.  With funds and ETFs holding cash and stock and, in some cases rapidly turning over their portfolio holdings, investors in these vehicles never really know what their true asset allocation is.  

Investing in individual corporate bonds addresses the above issues. They enable you to pinpoint your asset allocation down to the bond and maximize your returns, all in a security that pays you a fixed coupon and returns your principal at maturity.



 

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