What's Next in the Bond Market?

Bonds had a huge upswing in 2009 and many are wondering with interest rates so low (and nowhere to go but up) as well as a mounting deficit that may lead to increasing inflation, what's the best course of action. In short, just as there is no way to time the stock market, there is likewise no way to time the bond market, and in investing, there is no free lunch. You can't reduce risk and increase reward; nothing is guaranteed. Having said that, due to the various unusual economic conditions at play, I do think investors can make certain movements in their bond investments that have a higher likelihood of paying off.

John Waggoner argues in a recent USA Today article, "Those who dived into bond funds due for splash of reality," that "there is no good reason to own a bond fund." Investors put a record $349 billion into bond funds through November. Because of rising interest rates and inflation in the next few years (which seem to be reasonable bets), bonds have nowhere to go but down as their NAV takes a beating in these conditions. Waggoner recommends looking at laddering bank CDs and purchasing TIPS.

I hardly think it's the case that there's no good reason to own a bond fund as it offers diversification and there's no way to time the market. Having said that, because of the conditions mentioned above, I do think is a viable action to shorten the average duration of your bond funds (i.e. go to short-term) and perhaps be lighter on moderate and long-term treasuries and heavy on TIPS. As interest rates rise, short-term bond funds' NAV will be hit much less than those with longer durations. Similarly, treasuries are more likely to take a beating than corporates, although some prefer to safety of treasuries as it's backed by the full faith of the US Government.

In the end, I think it's reasonable that if you have 100% of your bond allocation in a total bond market index such as VBMFX, to put 50% of that into a different investment such as TIPS, a CD ladder, or a short-term bond fund. What bond fund to choose? Well, two popular choices these days are VFSTX (Short-Term Investment Grade) and VBISX (Short-term index containing ~50% Treasuries and 25% government backed).

In 2008, VBISX was up 5.4% while VFSTX was down 4.7% (we're talking total return not just capital appreciation), while in 2009 VBSIX was up 4.3% and VFSTX was up a whopping 14.0%. So, as you can see, the risk/reward profile of VFSTX (and it's volatility) is certainly greater than that of the more diversified VBISX. The reason corporates performed poorly from late 2008 into early 2009 was that the safety of US Treasuries was alluring to investors as the economy was still on shaky ground, so corporates went way down in price while treasuries went up. At current levels, however, situations have reversed and many think US Treasuries are overpriced while corporates have already seen the worst and are undervalued in regards to their NAV. (Considering yield to get a better grasp of total return is also significant. Don't chase yields, however. Just for the record, VBISX is current yielding 2.85%, while VFSTX has a yield of 3.95%. A bond fund with a higher yield nearly always contains higher risk.)

It comes down to what risk/reward profile you want to take in your short-term bond position. Corporates are riskier by the mere fact that the chance of a corporation defaulting is higher than that of treasuries. Thus, if you want to take the risk of a higher return with also the caveat of knowing there's a possibility of a negative return (and are willing to hold through that instead of taking part in panicked selling), then short-term investment grade seems like the wise choice. Jason Zweig thinks in the current conditions corporates are the way to go. Note that while I'm saying "higher risk," this risk of VFSTX pales in comparison to high yield or junk bonds as well as all stock funds. So, we're not talking about a super risky asset class. The worst case scenario is pretty much 2008 when it was down almost 10%. If you want to play it more safe and the purpose of your bond holdings is for steady income, choose VBISX (or even VSGBX, Short-Term Federal) as it's more stable and has higher quality bonds.

Here is a nice summary from Schwab about what to expect out of Treasuries and TIPS, government mortgage backed securities (MBS), corporates, municipal bonds, high-yield/junk, and foreign bonds in 2010. To recap that article, they assert that: 1.) TIPS offer a better value than Treasuries, 2.) MBSs have limited upside, 3.) Investment-grade corporate bonds provide a benefit in the realm of higher yields, 4.) Muni bonds remain attractive for high-income investors, 5.) Junk bonds have run their course and have limited upside, and 6.) The weak dollar is driving the returns for international bonds.

Article: The 6 Biggest Investing Mistakes

A nice article in Money magazine for the typical investor recently came out by Burton Malkiel and Charles Ellis to remind us of common pitfalls that individuals tend to make. Malkiel is an economics professor at Princeton and author of A Random Walk Down Wall Street, while Ellis authored Winning the Loser's Game.

Here are the six mistakes they outline that I think are significant enough to repeat:

1.) Overconfidence - People tend to think they can out-smart other investors and beat the market. But invariably the results show otherwise, and the psychological factors at play often actually prove counterproductive as we tend to buy high and sell low when things aren't going so well. Staying the course with a solid portfolio and asset allocation, and perhaps even signing an agreement with yourself that you won't deviate from your plan, is the best option.

2.) Following the Herd - Investors tend to think of what's "hot" now and pour their assets into it after much of the population has done so. This feeds a bubble, such as Internet stocks in the late 1990s and real estate in 2008, and rarely turns out well. Furthermore, just doing what millions of others have already done again ensures that you'll buy after the movement. The upward movement is over and you lost your chance. As Warren Buffet has said, "Be fearful when others are greedy, and be greedy when others are fearful." That is, it is to your benefit to go against the herd. When everybody was dumping stocks in late 2008, that was the time to pick them up, and you would have been rewarded handsomely for doing so.

3.) Timing the Market - I dedicated a fairly long post to exploring a common market timing strategy and timing based on "when you think is best" is the worst and most common form of market timing out there. Behavioral psychology dictates that we are poor barometers of where the market is going to go next, and we tend to buy when we've been burned (i.e. there's been a correction) and hold on when we're doing very well (i.e. there's been a huge upswing). In actuality, you want to do the opposite. However, even if you realize this fact, it's impossible to know when the market is going to change courses, so your best bet is to hold constantly. Furthermore, constant buying and selling increases commission costs, taxes, fees, and perhaps some opportunity time will be lost. And you're spending way too much time on your investments for your own good. There's a reason that 95% of actively managed index funds can't beat the market averages over a 10-year span, and these are professionals. Do you really think you can do any better?

4.) Assuming more control than you have - There is not stock market pattern to ascertain and the daily, weekly, and even monthly results of Mr. Market (as Benjamin Graham called it) is completely random.

5.) Paying too much in fees - This is one factor that I constantly emphasize and it is the key to maximizing returns in a way that you can control. Funds with low fees (typically 0.30% or lower) outperform those with high ones almost overwhelmingly. It's hard to make up for that with great picks - and as they say, those funds that have done so in the past are unlikely to do so in the future (past performance doesn't guarantee future results). Another advantage of low-cost index funds is that they're typically more tax-efficient since they're low turnover compared to actively managed ones. So, not only is your return most likely higher, but Uncle Sam takes a smaller portion of your profit.

6.) Trusting stockbrokers - Your broker isn't your friend. He's there to make money for himself. (Sidenote: If you have a financial adviser, make sure he is hourly/fee-based and not on commission. Those on commission tend to try to sell you investments that you don't want.) And your friends, while they mean well, don't know what's going to happen next in the market (nobody does). Going from stock tip to tip simply increases your commissions, adds to your tax bill, and typically ends up performing worse than if you had chosen a reasonable low-cost diversified index fund approach and stayed the course.

These pieces of advice from two very knowledgeable individuals cannot be repeated too many times. Most individuals think that they can easily out-smart the market, time it well, get in when a sector is hot, and trust others for stock picks. None of these typically end well.

Dollar cost averaging vs. lump sum investing

After devising an asset allocation plan, many investors wonder if it is wiser to immediately pour all of their assets (which are most likely sitting in cash) into the funds within their plan (lump sum) or to split the investments across several months (dollar cost averaging).  So, what method makes more sense for the majority of investors?

Simply put, if your goal is to maximize returns over the long-term, lump sum (LS) is the better course of action than dollar cost averaging (DCA) as it always has a higher expected return.

University of Chicago professor, Geoge Constantinides, supports this theory using complex mathematical and economics models in his paper, "A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy," which can be found here.  To break it down to the most simplistic premise, this conclusion makes perfect sense as it should seem obvious to any rationale observer that LS provides a higher likelihood of greater return than DCA because the market typically increases over time.  That is, since one expects the market to have a positive return, getting in it sooner rather than later is always the best bet.  Stated in another way, since the expected return of stocks and bonds is higher than that of money market funds and savings account, moving your assets immediately from asset classes with lower expected returns to higher ones will always increase your expected returns.  However, there is certainly no guarantee that this will play out in all situations and your actual returns may vary.  Thus, there is an important psychology at play when investors choose between using LS or DCA.  Another study concluded that LS beats DCA about 65% of the time - this number is not surprising since the stock market increases about 65% of the time.

Another argument for LS investing is that if you have set up an asset allocation plan of stocks/bonds that matches your risk profile and time horizon, why not follow it immediately?  If you decide that a 70% stock/30% bond mix is best for you and currently have $50,000 sitting in a savings/checking account, many would argue that you should implement the plan right away as it matches your directives.  Why would you want a 20% stock/10% bond/70% cash allocation for a quarter of the year (assuming you're DCA four times over the course of a year)?  If 70/30 makes sense for you in the long-term, then it makes sense now.  If you can't stomach the up's and down's that portfolio can sustain, then perhaps it's not appropriate for you.  These points certainly have merit and from a mathematical and statistic standpoint, LS is the way to go.

Having provided ample documentation that LS investing provides the higher expected performance over the long-term, I still don't want to make a blanket statement that everybody should utilize the LS strategy; and that is because of psychological factors and risk.  If you are a new investor that seeks to enter the stock market, but are a bit timid about the prospects of such a volatile asset class, then I think DCA is a good method.  Additionally, spreading out your investments over time certainly does reduce risk (although with a lower expected return).  There is no way to time the market and it is expected to increase in value over time, but spreading your investments into an index fund over the course of a year or so might make sense if it allows you to "stay the course" (i.e. not deviate from your designed portfolio asset allocation) over your lifetime.  As Warren Buffett has said, "My best holding period is forever."  DCA provides a method in which to spread out risk in case we have another year like 2008 even if it does have expected lower returns.  This rationale is certainly not without merit (sorry for the double negative) and for certain investors, DCA makes sense.

Note that even if you invest in a lump sum right now, you will still most likely be dollar cost averaging over the course of your lifetime as new funds become available.  I like to rebalance by buying additional shares of my existing funds, rather then selling my underperforming asset classes (unless, of course, I am tax loss harvesting, in which case selling negatively performing asset classes is the way to go).

To wrap up, lump sum investing provides the higher expected return over dollar cost averaging.  From a mathematical and probability standpoint, it is definitely the better method.  However, there are psychological factors at play in many circumstances and certain individuals may find comfort in spreading out their risk over the course of a year or so, and thus will find the dollar cost averaging method more suitable for their goals since it reduces their risk of picking the exact wrong time to jump in the market.  In the end, it won't make a huge difference over the course of a long-term investing lifetime.  Getting a suitable plan in place and implementing it is far more important than the rate at which you will be transferring your assets from cash to stocks and bonds.

Schwab Now Offers Commission-Free ETFs

I'm not sure how I missed this, but Schwab is now offering domestic and international ETFs with low expense ratios and they trade commission free for investors with Schwab accounts! This is a great and welcome move by Schwab to enter the ETF business. They are a couple years behind Barclays Global Investors (iShares), Vanguard, and State Street (SPDRs), so they certainly felt the pressure to add extra incentives (commission free and low costs).

You can see a comparison of the main four companies ETF offerings here. While Schwab certainly still doesn't have the breadth of offerings of the others, they do offer five domestic equity ETFs and three international equity ETFs that serve as a solid foundation for a portfolio. These are certainly nice choices for current Schwab customers who prefer the flexibility of ETFs as well as the increased ability to tax loss harvest. I wouldn't take the effort to move my accounts from Vanguard to Schwab, for example, quite yet. The differences are negligible, but increased competition is always a good thing and giving investors more low-cost indexed ETFs is definitely a positive. And the commission free aspect is icing on the cake!

I actually might use Schwab International Small-Cap Equity ETF (SCHC; available in January) with its 0.35% expense ratio as opposed to Vanguard FTSE All-World ex-US Sm Cp Index (VFSVX), which has a 0.75% purchase and redemption fee (on top of the 0.68% ER), or Vanguard's ETF version (VSS; 0.38% ER) since I got charged a commission every time I purchase that ETF. Many don't have International Small-Cap as part of their portfolio, so in that case, it would not be particularly important. Likewise, the Schwab Emerging Market ETF might be a viable alternative (for current Schwab customers) to Vanguard's fund, VEIEX, which charges a 0.25% purchase and redemption fee.

It's important to note that the Schwab domestic ETFs track slightly different indices than the Vanguard counterparts, so it's possible that these could be used for tax loss harvesting and wouldn't trigger a wash sale. Although please consult your financial professional to confirm this. It appears that the domestic ETFs track the Dow Jones indices, while the international ETFs track the FTSE indices.

You can read a discussion of these new offerings on a thread at the very pro-Vanguard site, Bogleheads. Some are resistant as they've thought for years that Vanguard is the best firm by far and nobody can challenge them, but, in the end, most welcome the increased offerings. I certainly do.

Update 1/7/10: Schwab has announced that they are reducing trade commissions to $8.95 to all clients regardless of portfolio size and activity starting 1/19/10. In the past, only those with greater than $1 million in household assets or those who traded at least 120 times per year got that rate - all others were $12.95. Schwab is really making a push to be a one-stop shop for all banking/investing needs. First, they created a high yield checking account and eventually a high yield savings. Then they reduced their expense ratios on their index funds to Vanguard-like levels that also only have a $100 minimum. They have a quality 2% cash back Visa. Then offering commission free ETFs and finally reducing commissions for trading stocks and ETFs! There are still a few places they are lacking, but they're certainly making a valiant effort to improve. They still don't have great bond fund choices as they're quite expensive (there are some on their OneSource list that are decent, however, such as those from Ridgeway), their fund offerings aren't nearly as extensive as Vanguard (e.g. no emerging markets), some of their funds seem to have higher tracking errors and tax cost ratios than their Vanguard counterparts, and they still charge a ridiculous $49.95 for every fund purchase not on the NTF list. However, Schwab is great for those with a small amount of assets and people who like to have all their money with one company as the multitude of positives outweigh those few negatives. I'm certainly a fan and welcome the changes; although they could be even better as could most firms.

Questions from the Mailbag - Segment 1

Below are some questions and answers based on e-mails or users' web searches that led them to the site:

Q: Should I hold TIPS in a taxable account?

A: Since bonds and bond funds are not very tax-efficient, they are best placed in tax-advantaged accounts such as a 401(k) or IRA. For tax efficient placement, consult this bogleheads article. Stock index funds tend to be the most tax efficient, while high yield bonds, REITs, and actively managed small caps lead to the most negative tax ramifications. Having said that, there are situations in which holding TIPS in taxable accounts makes sense. You should consider your portfolio as a single entity and determine your desired asset allocation. If, for instance, you decide that you want to dedicate 10% of your assets to Vanguard HY Corporate (VWEHX), 15% to Vanguard REIT Index (VGSIX), 10% to Vanguard Total Bond Market Index (VBMFX), and 10% to TIPS in the form of Vanguard Inflation Protected Securities (VIPSX), yet your retirement accounts only account for 30% of your total assets, then you have no choice but to place TIPS in a taxable account. Being the most tax efficient as possible is not nearly as important as maintaining your desired asset allocation based on your investing objectives, time frame, and risk tolerance. In the above hypothetical situation, High Yield Corporate Bonds and REITs are even more tax inefficient than TIPS, so it is the most logical to place those in tax-advantaged accounts first and purchase TIPS in taxable accounts. To make a long story short, ideally it is best to purchase TIPS in a tax-advantaged account if possible since they aren't the most tax efficient asset. However, there are certainly even more tax-inefficient investments and your asset allocation takes precedence. If the space in your tax-advantaged accounts don't allow for TIPS to be wholly purchased in them, then it is certainly a wise decision to purchase them in a taxable account over not purchasing them at all.

Q: How many assets should I have before investing in REITs?

A: There is no correct one size fits all answer to this question. I personally like REITs as a portion of one's portfolio as historically they have not been heavily correlated with other equities and returns have also been very strong. It's just a diversification argument; the more diversified you are, not only do you have greater protection against the downside, but the upside also has greater prospects. First, determine you desired allocation to REITs. Most plans allocate anywhere from zero to 20% of total assets. With a small amount of assets, I would recommend diversified REIT index funds as opposed to a single company. Vanguard REIT Index (VGSIX), for instance, requires a $3,000 minimum initial investment. For argument's sake, let's say you chose to dedicate 10% of your portfolio to REITs. In order to invest in this fund with your desired allocation (10% in this case), you need $30,000 in total assets. Further complicating this matter is the fact that REITS are incredible tax-inefficient and pay out 90% of their income in the form of dividends taxed at the normal income rate (i.e. not the 15% long-term capital gains tax rate). Thus, if you have no tax-advantaged accounts at all and a small amount of assets, I personally don't think the increased diversification is significant enough to overcome the tax burden and would just increase my allocation devoted to equities.

There are certainly other diversified REIT investments out there available besides the Vanguard fund. ETFs require no minimum investment and thus you could essentially have less than $100 and still devote some of your money to REITs. In that case, though, transaction costs would be prohibitively expense and ETFs make little sense for small purchases. Charles Schwab also offers the Schwab Global Real Estate Investor Fund (SWAIX) with just a $100 minimum. Thus, if you targeted a 10% allocation, your total assets just need to be $1000. And if you targeted a 20% allocation, you need just $500. That is certainly a viable alternative, although note that it has a fairly high 1.05% expense ratio and its performance has been largely different than Vanguard's "equivalent" fund (i.e. their investment choices are quite different than the index fund alternative; compare the charts and holdings information). Now, with such small amounts, it's not really going to make a big difference either way (i.e. choosing to invest in REITs or not), but getting invested in a diversified set of assets early could make sense to enforce good habits as long as you're keeping expenses low.

To that end, I typically recommend getting involved in REITs through a diversified index fund such as VGSIX with an allocation of 5-20%, so the absolute minimum assets that one should have before investing in REITs seems to be around $15,000, assuming you are comfortable with a 20% allocation. This is certainly not a set number for everybody and you should take your own personal circumstances into account, but it is a starting point at which I think diversifying with REITs will truly make a significant impact.

Q: Should I purchase a Total Bond Market Fund or TIPS?

A: I encourage the purchasing and allocation of funds to both. Just as advisers preach diversification across sectors and types of stock, it is important to diversify across the bond market. One might argue that the Total Bond Market (VBMFX) is enough diversification, but I personally believe TIPS (VIPSX) are also an important component of one's portfolio. If you don't have enough assets to invest in both, however, I'd most definitely start with the Total Bond Market fund. Many people encourage 2/3 of the bond allocation going towards Total Bond, while the remaining 1/3 goes to TIPS. Others say a 50/50 allocation makes more sense. Decide what makes the most sense for you. Another alternative to the Total Bond Market/TIPS split, is a Treasury fund (short-term or intermediate-term)/TIPS split in similar proportions. Some believe only Treasury bonds are fully dependable and thus avoid the corporate and mortgage related bonds. If somebody's bond portfolio was 50% Vanguard Intermediate-Term Treasury Fund (VFITX) and 50% Vanguard Inflation Protected Securities (VIPSX), I'd give that the go ahead most likely depending on their personal circumstances. Likewise, 2:1 or 1:1 Total Bond:TIPS ratio is also a well-rounded strategy as a play on the bond market.

Q: Would it be advisable to place my emergency savings in a short-term bond index fund?

A: Most financial advisers would tell you "no." Emergency savings are there in case disaster strikes, and you need the assets to be available and liquid, they argue. Bond funds do carry risk and you can certainly lose principle. Savings and money market accounts are safe, FDIC-insured, and reliable. I am, however, going to go against conventional wisdom and argue that in this current economic climate (i.e. extraordinarily low interest and money market fund rates), I think it does make sense for certain individuals to invest a portion of one's emergency savings in a short-term bond index fund, assuming the potential losses are acceptable. For example, placing 3-months living expense in a savings account and 6-months living expenses in a short-term bond fund (in which you plan to hold longer than the duration of the bond issues) assuming you can handle a 5% loss on your investment in those months would be an acceptable level of risk for the increased potential for returns, in my opinion. Note that typically advisers encourage a 6-month expenses emergency account, but in the current employment market, most have increased that to at least 9-months.

In taxable accounts, where emergency savings are typically placed (although it's possible to come up with a strategy to place them in tax-advantaged accounts), it might make sense to check out tax-free municipal bonds since other bond funds are typically not very tax efficient. Use a tax-equivalent yield calculator, such as the one found here, to find out if it makes sense based on current yield rates and your tax bracket. If so, I'd stash a portion of emergency savings in Vanguard Limited-Term Tax-Exempt (VMLTX) or something similar. If not, Vanguard Short-Term Treasury (VFISX), Vanguard Short-Term Bond Index (VBISX), or Vanguard Short-Term Investment Grade (VFSTX) are good choices. Jason Zweig argues in this September 19th Wall Street Journal article, that current conditions make Treasuries the riskiest type of bond right now ("If the economy improves and rates rise, [Treasuries] will get hammered. The longer the bond, the harder the hammering") and recommends Vanguard Short-Term Investment Grade (VFSTX), which currently yields 4.17% and has a duration of 1.97. You should not chase yield, however, under any circumstances. And with distributions coming up at the end of this year, you should be cautious when entering a bond fund at this juncture.

Q: Can Mutual Funds be shorted?

A: No, however, there are inverse mutual funds that increase in value when their market benchmarks go down. I do not recommend such funds. But if you're interested, the largest ones are offered by Rydex, ProFunds, and Direxion. There are also inverse ETFs and leveraged ETFs (that go twice the inverse the benchmark on a daily basis). For a list of inverse funds and ETFs, see here. I especially hate leveraged ETFs. They are extremely dangerous and do not behave the way most investors would expect. These should also be avoided. ETFs can be shorted, however. I likewise do not personally recommend such an action.

Q: Should I invest in index funds or actively managed funds?

A: Index funds have outperformed 60-70% of actively managed funds after taking expenses into account year after year after year. Those active funds that do outperform on any particular year, typically perform worse the next year. Chasing "hot" funds proves to be costly and index fund investing has shown to be a better, more cost efficient method. I subscribe to the "dollar cost averaging into diversified low-cost index funds over the long-term based on your objectives and risk tolerance" philosophy of investing.

Q: Should I hold Vanguard LifeStrategy Funds in a taxable account?

A: LifeStrategy Funds are all-in-one fund-of-funds that are designed to simplify investing and designate one's assets to various asset classes based on risk tolerance. Vanguard LifeStrategy Growth (VASGX) is the most aggressive fund, currently allocating 81% to stocks and 12% to bonds, while Vanguard LifeStrategy Income (VASIX) is the most conservative fund, allocating 22% to stocks and 65% to bonds. Since bonds are inefficient from a tax perspective, it does not make sense to hold a fund heavily invested in bonds in a taxable account. Due the simplicity of such a fund, one with an aggressive portfolio (i.e. skewed towards equities), a smaller number of assets, doesn't want to rebalance, or just wants an extremely simplified approach to dollar cost averaging or investing in general might choose a single all-in-one fund. However, because LifeStrategy funds hold the Vanguard Asset Allocation Fund, which adjusts its allocation and thus realize capital gains, these all-in-one funds are not as tax efficient as the Vanguard Target Retirement Funds, which do not hold the asset allocation fund. Thus, for those seeking an efficient all-in-one fund for a taxable account, look into the Target Retirement Fund with your desired asset allocation for the taxable portion of your assets. Ignore the year in the name; just look at the stock/bond percentages. You should still strive to hold most of your bonds in tax-advantaged accounts, but holding some in taxable accounts is okay. In the end, the Target Retirement Funds are better than the LifeStrategy fund for taxable accounts. Just make sure to revisit the allocation in the future as the target retirement funds automatically adjust as they get closer to the end date, unlike LifeStrategy funds. The tax advantages of TR funds, however, outweigh this negative.

Please send any investing questions to theinvestingguy (at) gmail (dot) com!