Thursday, September 9, 2010

Which Mutual Fund is Better?

The world of conservative investing that has developed over the last couple of years has done so with sound reasoning.  People who buy fixed income believe that in doing so they are protecting their investments in the safety of debt.  That debt, be it from Treasuries or corporate bond issues has seen prices rise while yields drop.  yet they continue to put money in what many are now seeing as the next bubble.  But many equity fund managers are now suggesting that this bull market in bonds is about to end as unemployment continues and economies around the world still struggle.  Are equity funds worried about the investor or the fees they are (or are not) generating?

David Pauly, writing in Bloomberg pointed out that "These managers are concerned about their fees: On a dollar- weighted basis, stock funds on average collect 76 cents in fees for each $100 invested compared with 61 cents at bond funds." Even as money flowing into bond funds increases, PIMCO, the world's largest bond fund company predicts that this bull market in bonds is poised for collapse. When is subject to debate.

We have near zero interest rates, the housing market continues to see price stagnation and there doesn't seem to be any concerted effort by the government to get back into the stimulus game.  Unfortunately, it is the stimulus provided by government that has allowed us to get this far, even if "this far" is still short of where we should be in this economic recovery.

Because investors still see the potential for yet another slide into recession, bond fund inflows have increased as a compared to their equity counterparts.  While these investors are doing so because the believe that bonds still are far less risky than stocks, they may simply be kidding themselves.  Risk, the much needed element in any portfolio seeking to grow, is not something bond investors necessarily believe they are taking when they channel their money into these investments.

That risk is the price.  Bonds are priced based on the willingness of investor to pay for safety and the more they believe this, the higher the price goes.  As the price goes up, the yield falls.

Should the economy double dip, this bet will be worth taking.  But if investors (even if they are prompted by their money managers to get back into the stock market - as Mr. Pauly suggests because of better fees charged by the equity funds they represent) decide at some point that the economy is improving, the sell-off will leave a lot of late-to-the-game investors holding losses they didn't think possible.

Mark Trumball, writing in the CSMonitor outlines this risk: "It's hard to predict when a shift will occur, but at some point, many investment strategists warn, Treasury bonds will become the worst-performing bonds of all. That's precisely because these bonds are considered to be among the safest investor havens during hard times. If a crisis mind-set eases, Treasuries have run up so far in price that they have the furthest to fall."  Should this shift occur suddenly, not only will individual investors be in trouble, but large pensions funds who have difficulty moving quickly, will also suffer.

Inflation also plays a role.  Bond investors will demand some compensation for the increase in inflation, something that has been so far, benign. Robust recoveries usually indicate an increase in inflationary pressures and there is no indication that this recovery could be described that way. Bond gurus also point out that if the bond bubble should burst, should inflation suddenly spike, the retreat away from bonds will not mirror that sudden retreat investors in equities often exhibit.

Vanguard points out that the safety in bonds is likely to be less dramatic in large part because as bond prices drop, yield will increase. And this will keep many investors with a choice: keep the bonds they have flocked to or sell them for the rising opportunities in the equity markets. But Vanguard's prediction that investors will simply freeze may not take into account the nature of investor behavior. They are in bonds because they were frightened of losing their hard-earned money.  But if they see a return to out-sized gains in the stock markets, they may just vote with their feet again.

Vanguard argues that in no matter what happens, bond investors will still do good. In a bad economic situation, the point to historic likelihoods by suggesting the investors who stayed in bonds saw a high relative return.  In a good one, they point out the higher nominal returns will occur. They point out that the rise in interest rates will affect the short-term bond more than the long-term.  Their analysts see a rise (over the next five years) in 2-year Treasuries from 0.81% to 5.28% (rates for longer termed bonds will rise less dramatically from 4.43% to 5.56% over the same five year period).

But this depends on numerous factors including a steady inflation rate, the continued purchase of US debt by foreign banks, predictable increases in the Feds fund rates, modest GDP increases and you. If you hold steady, these predictions will probably come to fruition.  But if things improve in the equity markets and you panic, the bond bubble will burst, albeit slowly, in spite of Vanguard's argument that you will still do okay if you had done nothing.

Paul Petillo is the managing editor of

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