Investors are always looking for the next big thing. By the amount of time and energy devoted to talking heads divining tea leaves and spouting stock tips on news programs, cable TV and the internet, you would think that the only market that counts is the US stock market.
In fact, the global bond market actually dwarfs the stock market by a factor of two to one. According to the December 2010 Asset Allocation Advisor, the amount of outstanding debt in the world tops $91 Trillion compared to the $52 Trillion market value of all stock markets around the globe. Of this all US stocks are valued at only $17 Trillion.
There is a mistaken belief among investors that bonds are only for “conservative” investors or those who are retired. Stocks are exciting. Bonds are boring. If we have learned anything from the financial collapse triggered by mortgage bonds in 2008, bonds are anything but boring. The important lesson is knowing that bonds are not to be ignored and can play an important role in a diversified portfolio when done right.
What’s an investor to do? Build a better mousetrap.
Most investors, if they have any bond exposure at all, will buy them through a mutual fund. While mutual funds offer instant diversification and professional portfolio management, there are limitations. In no particular order, these are: costs, inability to control for taxes, lack of customization and what is known as “NAV” risk.
For actively managed bond mutual funds, the average operating costs (or expense ratio) can exceed 1% per year. For index or passive bond mutual funds, the costs can be less (sometimes as low as 0.2% per year) but you will only have access to a statistical sampling of bonds. With either option you lack the ability to customize the holdings to match your specific needs for generating income or control the timing of sales which may be important from a tax perspective.
Another problem, NAV risk, is little understood by consumers. Mutual funds are priced daily. A value is determined for each of the mutual fund’s investments (closing price times number of shares or units owned). And this total is divided among the total number of mutual fund units outstanding. This Net Asset Value is the number you see in the charts and tables on line or in the newspaper.
With a mutual fund there is a constant flow of money coming in to buy more units or flowing out to cover redemptions made by other investors. Sometimes there is a mismatch between these flows. If there is a “run on the bank” and lots of redemptions occur, the mutual fund may be forced to sell holdings at “fire sale” prices intended for long-term investment to raise cash to meet the demands caused by redemptions. For those investors who hold on, they can be punished in the near-term by seeing the NAV fall and dragging down the value of their holding. That’s the NAV risk.
In the next part of this blog, I’ll talk about the ways to help reduce the impact and costs of these problems by building your own portfolio of bonds.
For additional information or help with investing, call Clear View Wealth Advisors at 978-388-0020 or 617-398-7494.