Individual Bonds Versus Mutual Funds

Potential clients I meet with sometimes have a portfolio of individual municipal bonds that they have purchased through a stockbroker. In far too many cases, the investors don’t really understand exactly what is in their investment portfolio.  They believe that because they have more than a dozen different bonds that they have essentially diversified their risk.  Generally, this is not the case. Moreover, these investors have no idea how much it really cost them (in the way of commissions or mark-ups) to purchase their bonds.

Whether or not you have a portfolio of individual bonds, you may still benefit from reading this because, the fact remains, what you don’t know about investing can hurt you financially.

As discussed in a previous post, many bond investors inadvertently take on excess risk by buying high yielding (generally synonymous with low quality) bonds.  This post discusses the trade-offs between buying individual bonds and owning a bond mutual fund.

Municipal Bond Funds and Individual Bonds, a report prepared by the Vanguard Group, discusses the pros and cons of buying individual bonds or mutual funds.  As you may know, the Vanguard Group is in the mutual funds business, so you might be suspicious of its conclusions.  Although their analysis could be construed as self-serving, I am, nonetheless, convinced that they are right.  My advice is that you read the entire 11 page report, but if you don’t have the time, here are some relevant excerpts. (Emphasis added.)

Municipal bonds—overview and investment considerations

Municipal bonds are initially issued in the primary market, where pricing is based on market conditions and demand.  It is generally more cost-effective to buy these bonds in the primary market, but institutional (mutual funds, pension funds) buyers dominate that market, and historically, it has been difficult for individual investors to compete with them for the limited bond supply.  As a result, most non-institutional trading is relegated to the secondary market, in which existing bonds are resold.

Drawbacks of trading municipal securities in the secondary market

Trading in the secondary market for municipal securities can be very problematic and expensive.  Unlike most other financial markets, in which price and execution are transparent to the investor via real-time bid–ask quotes, the secondary municipal market provides very limited real-time pricing and execution.

As a result, to be successful in this market requires deep knowledge, understanding, and experience in how it operates.  Compounding the problem is that, in the secondary market, purchases or sales in less than “round lot” quantities are marked up or down to reflect the unattractiveness of these sizes for bond dealers.  In addition, municipal bonds are not as actively traded as taxable bonds, such as U.S. Treasury or corporate issues.  As a result, municipal bonds are less liquid than taxable bonds and have higher transaction costs.

Comparison of municipal bond funds and individual bond portfolios

Several factors should be considered when evaluating the suitability of municipal bond funds versus individual bonds for a portfolio.  These factors include diversification, cash-flow treatment and portfolio characteristics, costs, and direct control of the portfolio.

Diversification

a.  A bond fund provides broader diversification than a portfolio of individual bonds.  Bond funds typically provide substantially more diversification among issuers, credit qualities, and maturities, as well as in the range of individual bond characteristics (for example, callable, noncallable, prerefunded, discount, and premium).

Much of this is possible because a bond fund has a larger pool of investable assets, along with the professional staff needed to conduct credit analysis.

For a self-directed individual, creating a well diversified bond portfolio typically requires a significant capital investment to obtain exposure across issuers, credit qualities, maturities, and so on.

Cash-flow treatment and portfolio characteristics

a.  Bond funds provide more timely investments of initial principal and periodic income cash flow.

b.  Bond funds provide more consistent risk characteristics (the most important of which is duration).  Because of their more regular, ongoing cash flows, mutual funds are better able than alternative vehicles to maintain more stable portfolio risk characteristics over time.

c.  Bond funds make liquidations, especially partial liquidations, notably easier.  Liquidating bond-fund shares does not change the characteristics of the fund’s bond exposure.

Costs

Our review of costs included bid–ask spreads, management fees, and sales charges or commission costs (collectively, “transaction costs”).  Costs are important because they directly reduce a portfolio’s total return.  For fixed income investments, as opposed to equity investments, costs tend to be a more significant drag on performance, and therefore exert one of the greatest influences on returns.

a.  Bond funds typically pay significantly lower bid–ask spreads than individual investors.  Retail trades of less than $100,000 per bond cost between 100 and 200 basis points morer than that for an institutional trade.

b.  Bond funds charge an ongoing management fee (expense ratio) for expenses related to the operation of the fund.

While the annual expense ratio is frequently cited as a drawback for funds, in reality it is generally more cost-effective to pay the expense ratio for years, rather than to risk paying a large spread when buying a bond.

Control of the portfolio

One advantage of self-directed individual bond portfolios … over mutual funds is the owner’s ability to influence portfolio decisions.

a.  Bond mutual funds don’t offer investors the ability to influence the selection of the bonds.

b.  Bond mutual funds cannot pass realized losses through to individuals.

c.  Bond mutual funds do not have a maturity date.  Therefore, the value of the fund at any point in the future is uncertain.

Conclusion

Vanguard believes that the vast majority of municipal bond investors are better served using mutual funds.  Only investors with resources comparable to those of a mutual fund can afford to put the control benefits of owning an individual bond portfolio ahead of the benefits of investing in a mutual fund.  The advantages of mutual funds over individual bond portfolios include better diversification, generally lower costs, typically higher after-tax returns, and more efficient management of cash flows and portfolio characteristics.  The advantages of individual bonds over bond mutual funds revolve primarily around control issues that result from direct ownership.  An investor must assign a very high value to those control aspects to justify the higher cost and additional risk involved in owning individual securities.

Note

The analysis focused on municipal bonds, but similar considerations apply to corporate bonds. Also, the Vanguard Group has very low cost mutual funds, so the trade-off is pretty clear between individual bonds and their mutual funds. Other companies, such as Fidelity or T. Rowe Price, also have low cost mutual funds, provided that you purchase them directly or through a fee-only financial advisor. If you purchase mutual funds through a stockbroker, you may end up paying very high fees, effectively negating the low-cost aspect of mutual funds. As always: Buyer beware.

60 Minutes – The 401(k) Recession

Sunday’s 60 Minutes piece on 401(k) retirement plans was rather shallow, and not at all what you would hope (and expect) from CBS’s popular, long-running show. The template for this type of exposé is generally that there is a problem/scandal and some party has been physically hurt or financially injured, and some other party has to bear the blame.

According to the 60 Minutes portrayal (sadly, all true, by the way), people have lost jobs, their portfolios were destroyed and retirement dreams must now be deferred. Steve Kroft interviewed discouraged job seekers at a job fair, which, if nothing else, provided sympathy and some activity to televise. It’s curious (and quite a coincidence!) how the interviewees just happened to have their 401(k) statements with them.

Naturally, he only interviewed older people, and that’s fine; after all, it’s the older folk who are more severely impacted. In my opinion, younger investors will be fine, as long as they continue to contribute to their own 401(k) plans and invest in stocks. In fairness to 60 Minutes, they did spend about a dozen words on this distinction.

According to my analysis of the 60 Minutes template, we must find victims and we must identify villains. Indeed, they found a very sympathetic woman who not only lost a lot of money in her retirement account, but lost her job as well. She cried on camera. And 60 Minutes made a veteran industry spokesman appear unabashedly unsympathetic, though that may have been the result of heavy editing of his comments.

Actually, the 13 minute piece combined two things: (1) people have lost money, and (2) fees are hidden in 401(k) plans and may be excessive. What they downplayed is that more consumer education is needed. Surely, they could have spared a few more sentences than the paltry few they uttered on that particular, very important, issue.

What can we actually learn from the 60 Minutes segment?

People Lost Money

Well, yes. But, what wasn’t said is that that has been true of other investment accounts as well, not just 401(k) plans. Small business owners have also suffered, as have people who have lost their jobs. Why only claim that 401(k)s have let down participants?

Fees

Yes, high fees can hurt investment performance, so 60 Minutes got it right that high (and hidden) fees can be a big problem in retirement plans. But they chose merely to list the types of fees, not quantify them or put them in a useful context. In my experience, some 401(k) plans are quite good. Some are too expensive. On the other hand, many 403(b) plans have very high fees, yet no one is examining them.

Risk

Defined Benefit Plans (pensions) have been in decline for some time. The old pensions were much better for average Americans, because loyal employees knew (more or less) what they would get, and they didn’t have to worry about making investment decisions. But employers were happy to get rid of traditional pensions to help reduce future costs and to reduce the business risk of achieving adequate market returns. Accordingly, employers have emphasized Defined Contribution Plans and largely dropped pensions.

In essence, investment management and investment risk were transferred to employees, and they were not prepared to make wise choices. In a bull market this was not so noticeable.

The Solution

The nature of defined contribution retirement accounts, such as a 401(k) or 403(b) plan, is that, while they provide a tax-deferred avenue to save for retirement, they need to be managed. Someone has to determine an appropriate asset allocation, based on a number of factors. Moreover, if you have other investments, it is ideal to treat all of your investments as one portfolio. And your allocations should probably change over time. As you get closer to retirement age, you generally will need to be somewhat more conservative in your investments.

The fundamental problem is that people thought that they could simply invest in the 401(k) plan without putting too much consideration into the asset allocation. Or it could be that they chose hot funds based entirely on past performance. The show did not go into any details as to why the participants had done so poorly, only that they had.

Clearly, more consumer education is needed. Fortunately, there are efforts currently under way to provide independent, unbiased support that will assist more employees to make informed decisions about their retirement plans.

Suggestion for 60 Minutes

The producers could have done a much better job. Next time, they should compare and contrast two people. One individual who had read a couple of personal finance/investment books or had consulted a financial planner who explained risk and return, asset allocation and the need to become more conservative as one approached retirement. The second individual would be one who did not understand any of these issues and pretty much just winged it with what amounts to a large part of her net worth.

While this comparison would have been useful and very telling, it would, of course, have made for pretty boring TV.

Rolling over to an IRA account

If you have a defined contribution account – 401(k) or 403(b) – from a former employer you can do a tax-deferred transfer to an IRA account. This would give you more control and more choices, but it should be done carefully. To that end, I recommend that you consult a fee-only financial planner. Otherwise, you may end up paying even higher fees than what you are now paying! You might even, heaven forbid, be sold a variable annuity to put in your new IRA.

To be continued.

Financial Literacy, Part 2

“What good is it if high-school students learn about Flaubert, biology, and trigonometry if they don’t learn how to take care of their money?” – Stephen J. Dubner.

In my last post, I discussed the importance of access to financial education and advice for everyone.

A post by Stephen J. Dubner, co-author of Freakonomics, asks a very provocative question: Are We a Nation of Financial Illiterates? 

He asks:
1. Do you consider yourself financially literate?
2. If so, how did you get that way?
3. How important is widespread financial literacy to the health of a modern society?

Dubner believes that financial literacy is a very important issue (obviously, or he wouldn’t have written the article).

To assess your own competence, answer Dubner’s three sample questions, which have, by the way, been used in national surveys. Note that only 1/3 of respondents 50 and older got all three questions right!

His prescription for increasing financial literacy is derived from an interview with Annamaria Lusardi, a professor of economics at Dartmouth. Given yesterday’s inauguration of Barack Obama, of particular interest is her answer to the question, “If you were president of the U.S. for a day (or longer), what are 5 pieces of financial literacy that you’d try to have taught to everyone?”

Dubner provides his own answer to that question.