Think Twice Before Investing in Bond ETFs

There are good reasons why equity ETFs have become popular: Their liquidity, low costs, and tax advantages have helped to make them useful tools for investors. But while equity ETFs have certainly earned a seat at the investing table, it's not as clear that fixed-income ETFs make as much sense as owning mutual funds that hold bonds. The reasons for our skepticism range from more or less minor details (such as the fact that you'll have to contact your broker separately to request that the monthly dividend payouts you receive from owning a bond ETF are reinvested) to three more-concrete points that we've detailed below.

Cost Benefits of ETFs Aren't So Clear
Bond ETFs are cheap--there's no doubt about that. Vanguard recently lowered an already low bar when it launched ETF share classes for four of its bond funds in April. The new Vanguard ETFs charge just 0.11% in annual operating expenses. Furthermore, iShares has a handful of fixed-income choices that are slightly more expensive but still a reasonable 0.20%. But while that's certainly cheap, investors can find several bond-index mutual funds that are also very inexpensive, including the conventional share classes of Vanguard bond funds. For example,  Vanguard Total Bond Market Index charges just 0.20% in fees. Furthermore, Dreyfus Bond Market Index Basic shareholders pay just 0.15% in expenses.

Add in another fact of ETF life--that you have to pay brokerage commissions to buy one--and traditional funds may actually have a leg up in this race. Commissions on ETF trades have dropped in recent years, bringing the average charge for an online trade to about $12. But depending on how you access them, you could make trades in traditional mutual funds for free. The negative effect that commissions have on returns becomes magnified for those who like to make regular investments into their funds, as they'll get dinged for every additional purchase or sale.

Tax Advantages of ETFs Are Less Relevant
Both index mutual funds and ETFs are very tax-friendly because they feature low-turnover strategies. The structure of ETFs makes them more tax-efficient than mutual funds, though. Mutual fund redemptions may force a fund manager to sell securities at a gain to raise cash, but ETF sales occur on the exchange and don't force a manager to do anything. Plus, if an ETF manager has to sell stocks to meet redemptions from major shareholders (or "authorized participants" in ETF lingo), he or she can offload securities with the lowest cost basis on them, thereby limiting unrealized gains.

Funds simply can't compete with ETFs in this regard. But while ETFs' tax edge gives them a leg up in the arena of stock funds, bond funds don't typically rack up sizable capital gains. For example, while  Vanguard 500 Index paid out some large distributions in the late 1990s, Vanguard Total Bond Market Index has distributed just $0.09 of capital gains in the past decade. As such, you're usually making out all right after taxes with a bond mutual fund, so the advantages of ETFs don't come into play to the same extent.

Rekindling the Passive vs. Active Debate
The argument over bond indexing is by no means an open-and-shut case, but a number of active managers have been able to outperform their indexes over time. That's because enough inefficiencies exist in the bond market for active managers to get ahead of indexes such as the Lehman Brothers Aggregate Bond Index. Rather consistently, a small group of funds such as  PIMCO Total Return have been able to find undervalued securities, such as the German government bonds it picked up in 2004, and employ other return-boosting tactics to beat the bogy. As of March 31, 2007, 38 out of 331 distinct funds in the intermediate-term bond-fund category have produced 10-year returns that top the Aggregate Bond Index's gain.

That's not a long list, to be sure, but low-cost bond funds with experienced managers and analytical might are out there, and a lot of investors have done very well by favoring them over passive fixed-income vehicles.

All in all, we still think there can be a place for ETFs--and most other cheap, tax-efficient funds--in investors' portfolios. And truly sophisticated investors may get some benefits from trading ETFs intraday or short-selling them. But given the strengths of traditional bond mutual funds, we continue to think that they serve most investors very well.

A version of this article appeared on Nov. 16, 2005.