Saturday, November 03, 2007

The Risk/Return Benefits of Shorter-Term, High Quality Bonds

The Risk/Return Benefits of Shorter-Term, High-Quality Bonds

Alejandro Murguía, Ph.D., and Dean T. Umemoto, CFP

Executive Summary

  • Fixed-income instruments are largely used within a portfolio to reduce volatility and provide a more consistent distribution stream for clients. Holding non-callable instruments backed by the U.S. government offer significant protection in times of financial crisis while reducing the long-term opportunity cost of bonds.
  • U.S. government instruments with maturities from one to five years present the most favorable risk/reward profile. Additionally, the term premiums for extending maturities begin to decline for longer-term bonds.
  • Mutual fund managers among the high-quality short-term (HS) and high-quality intermediate-term (HI) bond funds underperformed their corresponding government indexes and index funds over an entire decade. The average top quartile fixed-income managers in the HS and HI classes also underperformed their corresponding index funds.
  • We analyzed the credit composition of the ten top-performing actively managed portfolios across the HS and HI mutual funds. Much of the value-added returns from these actively managed portfolios seem to stem from additional credit and call-option risk.
  • There seems to be a direct inverse relationship between investment performance and fund expenses. The higher the investment return, the lower the fund expense ratio. Differences in expense ratios explain much of the differences in net returns.
  • Further analysis of the top performing funds reveals that non-active strategies such as an indexing or variable maturity approach may be an investor's best option.

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