Morningstar Cautions on Bond ETFs

[This article also appears on Seeking Alpha, Questioning The Value of Bond ETFs]

Early last week, Morningstar has an article cautioning investors on bond ETFs.

With the recent introduction of four Vanguard bond ETFs, it can be expected that investors will look into these new ETF offerings when building their portfolios. However, the article, Think Twice Before Investing in Bond ETFs by Paul Herbert, reminds investors that there are a couple of factors we should consider before jumping on the bond ETF bandwagon.

First, are bond ETFs bringing any benefits on the cost of owning them?

ETFs are generally cheap as compared to their mutual fund counterparts and bonds ETFs are no exception. However, given that bond mutual funds themselves already have very low expense ratio, the advantage of bond ETFs on fees over bond mutual funds may not be as obvious as that between equity ETFs and mutual funds. For example, as the article points out, Vanguard Total Bond Market Index (VBMFX) has an ER of 0.20%. The Vanguard bond ETFs, on the other hand, charge 0.11% in fees. The difference could become a non-factor when ETF’s trading cost is added.

Second, does bond ETFs offer tax advantage?

Another selling point of ETF is that it’s more tax-friendly than a mutual fund because “mutual fund redemptions may force a fund manager to sell securities at a gain to raise cash, but ETF sales occur on the exchange and don’t force a manager to do anything,” and the inactivity will effectively limits capital gain distributions. For bond ETFs in particular, the tax advantage isn’t that obvious since bond mutual funds distribute only a little in capital gains.

Finally, are active bond ETFs better than bond index ETFs?

Unlike in the equity fund world where active fund managers had hard time beating index funds over the long run, there are a number of active bond fund managers who have produced consistently superior returns for bond investors. As the article shows, as of March 31, 2007, “38 out of 331 distinct funds in the intermediate-term bond-fund category have produced 10-year returns that top the Aggregate Bond Index’s gain.” Thus, investing in passive bond ETFs may not give investors the returns they are looking for as compared to investing in actively managed bond mutual funds, even in the long term.

After making the above arguments, the article concludes that

All in all, we still think there can be a place for ETFs — and most other cheap, tax-efficient funds — in investors’ portfolios. And truly sophisticated investors may get some benefits from trading ETFs intraday or short-selling them. But given the strengths of traditional bond mutual funds, we continue to think that they serve most investors very well.

In summary, three key benefits, costs, taxes, and returns, that equity ETFs have enjoyed aren’t very appealing when it comes to investing in bond ETFs.

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