Those who wish to allocate some of their savings to bonds have a choice between mutual funds or exchange-traded funds (ETFs). While the two options are alike in that they provide investors with diverse exposure to various sectors of the bond market, there are a few key differences to understand:
Method of Purchase
There is a slight difference in the way investors can purchase mutual funds compared with ETFs. Mutual funds are typically purchased directly through the issuing company or through a financial advisor, but they are also available through brokerage accounts. While many fees have no loads, or up-front purchase charges, an investor who does pay this sales charge will be hard-pressed to keep up with the performance of ETFs once the deduction of this fee is factored into their returns. ETFs don’t have loads, which is a plus, but they do have transaction charges since they are bought and sold just like stocks. This also requires the investor to set up a brokerage account, which they wouldn’t necessarily have to do in order to buy a mutual fund.
Investors should factor all of these expenses (loads and brokerage fees) into their thinking when assessing the costs and benefits of mutual funds versus ETFs.
Costs are the major differentiator between mutual funds and ETFs. The average bond mutual fund has an annual expense ratio of 1.06%, but the average bond ETF has an expense ratio of just 0.42%. A difference of 64 basis points (0.64 percentage points) may not sound like much, but over time it can have a huge impact on returns due to the compounding effect this added cost has on perfromance year after year. Higher fees are of particular concern with bond funds, where expected annual returns are modest and 0.40 percentage points can represent a huge bite out of an investor's gain. This is even more of a consideration now given the ultra-low yields on higher-quality securities.
Learn more: Why Invest in the Lowest Fee Funds?
Mutual funds have a five-year performance advantage over ETFs, based on the returns of different categories through July 31, 2013:
- The Vanguard Total Bond Market Index Fund (ticker:BND) had a five-year average annual return of 4.70%, lagging the 5.82% average return for the mutual funds in Morningstar’s Intermediate-Term Bond Funds category.
- The Vanguard Short-Term Bond ETF (BSV) had a five-year average annual total return of 2.92%, behind the 3.25% average return of the Morningstar Short-Term Bond Funds category.
- The Vanguard Intermediate-Term Bond ETF (BIV) had a five-year average annual total return of 5.79%, behind the 5.82% average return of the Morningstar Intermediat-Term Bond Funds category.
- The Vanguard Intermediate-Term Bond ETF (BLV) had a five-year average annual total return of 7.53%, behind the 9.05% average return of the Morningstar Long-Term Bond Funds category.
- The iShares Barclays TIPS Bond Fund (TIP) had a five-year average annual return of 4.41%, outperforming the 3.80% average return for the mutual funds in Morningstar’s Inflation-Protected Bond Funds category.
- The iShares S&P National AMT-Free Municipal Bond Fund (MUB) had a five-year average annual return of 4.10%, slightly behind the 4.23% average return for the mutual funds in Morningstar’s Municipal National Intermediate Funds category.
The performance advantage favors mutual funds, which may be somewhat surprising given the rapid growth of ETF assets in recent years. One advantage of mutual funds is that their prices don't become disconnected from the value of the underlying securities in the portfolio during periods of market stress, which can occur with ETFs. Learn more about this issue here.
The bottom line: be sure to weigh all considerations carefully when making a decision, including tax issues, fees and the long-term results of the specific funds you’re thinking of buying.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always talk to a financial and tax advisor before you invest.