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Some question usefulness of bond ETFs

Posted by: Aaron Pressman on April 11, 2007

There are many ways for individual investors to tackle fixed-income investing. It’s easy and free to buy Treasury securities direct from Uncle Sam. You can even set up automatic rollovers. Many online brokers now offer direct purchase of government and corporate bonds for nominal commissions, although you have to be wary of the markups. And of course there are a bevy of actively managed and index-based mutual funds that includes a growing roster of exchange-traded bond funds. There are some, like blogger and investment manager Richard Kang, however, who question the usefulness of index-based bond funds.

First the news: This week, Vanguard rolled out four exchange-traded bond funds very similar to those on the market in Barclay’s iShares program. The new Vanguard Total Bond Fund (Symbol: BND) tracks the Lehman Brothers Aggregate Bond Index, as does the iShares Lehman Aggregate Bond Fund (AGG). The Vanguard Short-Term Bond ETF (BSV) tracks the Lehman one-to-five-year Government Index and Vanguard’s Intermediate-Term Bond ETF (BIV) uses the Lehman five-to-10-year index. Those are similar to the iShares Lehman 1-3 Year (SHY) and iShares Lehman 7-10 Year (IEF) funds. Vanguard’s Long-Term Bond ETF (BLV) uses the Lehman Long Government Index and matches up with the iShares Lehman 20+ Year ETF (TLT). Vanguard’s funds have ultra-low expenses ratios of 0.11% (or 11 basis points) versus 0.15% for iShares.

So what’s Kang’s beef? Basically, there’s no much difference among the hundreds of Treasury issues in the indexes so diversification isn’t as valuable as with individual stocks. And bonds you buy on your own pay a predictable rate of interest and full principle versus the varying yield and net asset value of a bond fund (which obviously never matures). The bond ETFs really are best used to add around the edges of a portfolio of bonds, he says today:

Unless you’re a complete novice who can’t build a laddered bond portfolio (or acquire an advisor who can do this), then bond mutual funds or perhaps these bond ETFs should be one of your final options to gain fixed income exposure. It’s almost like the opposite as what might be done on the equity side where you might have a core group of ETFs with stock selection as a “satellite” strategy.

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Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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