Why Bonds are Grossly Misunderstood

Here’s how to effectively add bonds to your portfolio.

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Many investors don’t understand bonds. The primary misconception is that bonds should be used to generate income. Especially in this low yield environment, you may be tempted by the higher yields offered by bonds with increased credit risk or longer duration.

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The primary function of bonds in your portfolio should be to lessen the impact of short term volatility in the stock market. The bonds in your portfolio should be limited to short-to-medium-term U.S. and foreign government bonds. It’s also prudent to globally diversify your bond portfolio, similar to what you do with your stock holdings. For exposure to domestic bonds, consider iShares Barclays Short Treasury Bond ETF (SHV). It tracks the Barclays Capital U.S. Short Treasury Bond Index and invests at least 90 percent of its assets in U.S. government bonds. Its expense ratio is a very low 0.15 percent.

For exposure to international bonds, consider SPDR Barclays Capital Short-Term International Treasury Bond ETF (BWZ). It tracks an index (the Barclays Capital 1-3 Year Global Treasury ex-US Capped Index) which consists of short term, fixed rate, investment grade debt issued by foreign governments of investment grade companies. Its expense ratio is 0.36 percent, which is very competitive for bond holdings in this category.

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Note that I am recommending your bond holdings should be in index funds. A recent article from Bloomberg News noted the dominance of bond king Bill Gross may be in jeopardy. Gross is the co-founder of Pacific Investment Management, better known as PIMCO. He is generally considered to be the preeminent bond fund manager in the country. Being a fund manager has obviously been good for Gross. Forbes estimates his personal net worth at $2.2 billion.

Gross is an active bond manager, meaning his funds attempt to beat the returns of a designated index. There is a looming threat to his empire: Compelling data indicates most active bond managers underperform their index.

Bloomberg reports that, based on research from the Vanguard Group, eight out of 10 bond fund managers have underperformed the U.S. market in the past 20 years. Over the past 10 years, 71 percent of active bond managers failed to beat the U.S. fixed-income market. That percentage increased to 85 percent over the past 15 years.

Investors are taking note of this data. This year, 39 percent of all new bond fund investments were invested passively. Currently, over $168 billion is invested in ETFs that track bond markets.

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When you purchase an actively managed bond fund, you are paying more (through a higher expense ratio) than you would pay for a comparable bond index fund. You are getting a fund which, based on historical data, is likely to underperform the bond index fund. It’s a gross misunderstanding.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.