I, like many in finance, am a big fan of William Bernstein’s prodigious output of books on investing (and economic history). For example, I mentioned a key insight of his on the changing nature of asset correlations in an earlier blog post. More recently Bernstein wrote a short (and nearly free) primer on investing for Millenials, If You Can: How Millennials Can Get Rich Slowly, who are likely in need of help as they get their investing journey underway.

In his most recent book, Rational Expectations: Asset Allocation for Investing Adults, Bernstein takes a more technical (and mathematical) look at the challenges of asset allocation today. See Brenda Jubin at Reading the Markets for a favorable review of Rational Expectations. In addition, Bernstein also participated in a Q&A with Phil DeMuth over at Forbes. What is great about Bernstein is that he does temper his views on fund industry. In this excerpt from Chapter 6 he asks whether individual investors need to bother at all with bond ETFs. That is not so great news to the ETF industry which has attracted some $276 billion in assets to bond ETFs as of May 2014.

The following is excerpted with permission of William Bernstein from Rational Expectations: Asset Allocation for Investing Adults. Copyright (c) 2014 by William Bernstein.


From Chapter 6: To ETF or Not to ETF

by William Bernstein

A persistent criticism levied against my books is that they’re “outdated” because I ignore ETFs. Guilty as charged: I do much ignore them, but not because there’s anything wrong with the ETF wrapper. Like open-end funds, there are good ones and there are bad ones. It’s just that a wrapper is, well, just that. As with most products, the wrapping doesn’t make a difference to the intelligent consumer. It’s what’s inside that counts.

I’ll take that one step further. Anyone who tells you that there is something magical about ETFs that makes them significantly better than open-end funds in the same asset class is blowing a large amount of an aerosolized sooty particulate cloud. In most cases, whether you use an ETF or open-end fund makes exactly zero difference. Consider this: Over the objections of founder John Bogle, Vanguard now offers an ETF class of virtually all of its open-end index funds. These ETFs carry the same expense ratio as the Admiral class mutual funds, invest in the same underlying pool of assets, have the same tax efficiency, and, therefore, have nearly identical returns in almost all cases. It cannot be any other way.

There are certain circumstances where the chosen wrapper does make a difference, the most important area being bonds. I highly recommend that you avoid all ETF bond funds. To understand why, I’ll need to explain some of the trading mechanics involved. An ETF, unlike an open-end fund, trades throughout the day at a discount or premium relative to the net asset value (NAV) of the underlying shares. In most cases, the spread between the two is minimal because shares are both created and liquidated by independent agents: “authorized participants” (AP) who buy up the securities underlying the funds and bundle them into ETF shares that are then delivered to the fund company. The same process also works in reverse to liquidate ETF shares. Were a significant spread to open up between the market price and NAV, the AP, in theory, should simply arbitrage that away at a profit.

This mechanism works well with stocks, which are highly liquid, but not with bonds, which are not. There is, for example, only one commonly traded class of Ford Motor Company stock. By contrast, Ford has a range of bonds of varying issue dates, coupons, and maturities. Since there are so many more individual bonds than stocks, the bonds can be highly illiquid. During a financial disturbance, when liquidity becomes even thinner and most corporate bonds trade only “by appointment,” the AP mechanism fails, often at considerable disadvantage to the shareholder. The open-end fund holder, who can always buy and sell at the 4 p.m. (eastern standard time) NAV, has no such problem.

For the lion’s share of your fixed-income assets, the entire mutual fund structure is, in fact, unnecessary. To repeat this book’s opening mantra: there are risky assets, and there are riskless ones, and the two play very different roles. Keep the two as separate as possible and make the risky assets as risky as you like. Critically, your riskless assets should retain their value in a crisis. Corporate bonds, in particular, have a modest amount of stock-like behavior and can see price falls independent of the rise or fall in overall interest rates.

Municipal bonds can also behave this way, and if you’re depending on either corporates or munis for liquidity during a crisis—precisely when you’re likely to want or need it the most—you may have to take a substantial haircut to realize it. Tax-sheltered investors should keep almost all of their fixed-income assets in government-guaranteed securities: Treasury bills and notes and CDs. And while taxable investors should own at least some municipal bonds, they should still hold a fair dollop of Treasuries and CDs, as well. The main point here is that you don’t need or want to own a mutual fund for Treasuries, and it’s neither desirable nor available for CDs.

When purchasing CDs, you will need to keep an eye on the FDIC’s insured limit of $250,000 per person per institution (though a good bank manager can get fairly creative in extending this limit by varying ownership and beneficiary designations). They can also be bought from a brokerage account, which has the advantage of convenience and immediate access, especially at maturity, when they simply roll into the cash/money-market balance. On the other hand, CDs sold by a brokerage can impose a haircut of principal if they are sold before maturity, whereas usually only a limited interest penalty is incurred when you redeem before maturity at the issuing bank. If you’re especially clever and aggressive, it is often better to buy a higher-coupon, longer-maturity CD directly from the bank. If sold before maturity, the extra coupon will usually more than make up for the interest penalty. Don’t try this at a brokerage.

Unless your account size is tiny, it makes no sense to own a Treasury or government-bond fund, since you can buy these securities at auction and hold them at no cost. The same goes double for TIPS, the main purpose of which is to pay for future real living expenses. You can, with a little effort, tailor a ladder to do so with the proceeds as they mature. If, on the other hand, you hold a TIPS fund, not only do you pay unnecessary fund fees, but there will likely be periods when you will be forced to sell these securities at disadvantageous prices, as happened to many investors in 2008–2009. Much as I love Vanguard’s low fees, there’s almost no reason to pay them even a penny for their TIPS and government-bond funds. Except for the smallest of portfolios, the same is largely true for bond index funds. Their largest holdings are government securities, but they also mix in a fair amount of riskier (i.e., stock-like) corporate bonds of lower quality.

The only bond funds you should own are open-end municipal and corporate bond funds (to the extent that you do own these two asset classes). The reason for this is simple. Without a great deal of effort and expense, the individual cannot put together a well-diversified low-expense mix of municipal or corporate securities. With munis, the choice is clear: Vanguard offers a wide variety of national and state-specific mutual funds.

Corporate bond funds are curiously problematic. For many years, Vanguard maintained a “corporate bond fund” series, which then inexplicably changed both its name (to the “investment grade” appellation) and its mandate, which was broadened to include government as well as asset-backed (credit card and car loans) and mortgage-backed securities. Although these funds have good long- term records, they proved especially vexing during the Global Financial Crisis—a classic case of “bad returns in bad times.” In 2008, the Intermediate Investment Grade Bond Fund, for example, lost 6.06%, versus a loss of 2.76% for the equivalent Barclays Intermediate Credit (corporate) Index, a remarkable showing considering that the fund held a significant amount of government bonds, which did well in the crisis. To be frank, I simply do not trust the management of this fund series. Even more remarkable, Vanguard has recently brought out, hooray, a series of corporate- bond index funds. Unfortunately, the intermediate- and long-term open-end versions of these funds come with purchase fees (0.25% and 1.00%, respectively). Only the short-term version Admiral Class shares come with no fee. (All 3 funds come as fee-less ETFs, but, as I’ve explained above, I do not recommend bond ETFs.)

A reasonable fixed-income allocation for a largely sheltered portfolio might be equal amounts of CDs and Treasury bills or notes. A largely taxable portfolio might be equal parts munis, CDs, and Treasuries.


You can read more by William Bernstein at Efficient Frontier or see a more complete list of his books at Amazon.

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