So you have read our article on individual bonds vs bond funds and have decided that bond funds are the best option for you. The next question you are probably asking is: Should I invest in bond mutual funds or Bond ETFs? Here are our thoughts.
Active Vs. Passive Bond Funds
The first question a bond investor should ask themselves is do they want an actively managed or passively managed bond fund? Most bond mutual funds are actively managed. The large majority of Bond ETFs are passively managed.
If you want an actively managed fund, then until there are more actively managed ETFs, the choice is straightforward: Bond Mutual Funds. If you want a passively managed fund, then some further analysis is needed in order to decide whether passively managed bond mutual funds or ETFs are better for you.
Don’t know whether you want an actively or passively managed fund? See our article “Active vs. Passive Bond Funds: Which is Better for You?”
Bond Mutual Fund vs. Bond ETF Costs
When comparing Bond ETF fees to Bond Mutual Fund fees You will often hear that Bond ETFs are cheaper than Bond Mutual funds. If you look past the surface however, this is not always the case. It is true that actively managed bond mutual funds almost always have a higher expense ratio than bond ETFs. However, comparing the average expense ratio of all bond mutual funds to the average fee for Bond ETFs, is really an apples to oranges comparison. The apples to apples comparison is Bond Index Mutual Funds vs Bond ETFs. When comparing passively managed bond index mutual funds to bond ETFs, the expense ratios look much similar, and one doesn’t really have a big advantage over the other.
Where costs really come into play is commissions. With almost all bond mutual funds you have the ability to invest directly with the mutual fund company without paying a commission. This option is not available with most bond ETFs, so you will normally have to pay a commission when buying and selling ETFs. If, like many people, you are investing small amounts on a regular basis, these fees can add up quickly, and make bond mutual funds the more cost effective option. For more on this read our article “Bond Mutual Funds vs. Bond ETFs, which is cheaper?”.
**Some mutual funds are also sold with a load which is taken out of the investment in order to compensate the financial advisor. However most index mutual funds are also available in no load versions, so we recommend never paying a load.
Bottom Line: When investing larger amounts of money all at once, the costs involved with bond index mutual funds and bond ETFs are generally in line with one another. When investing small amounts of money, investors can save a substantial amount by going with a bond index fund, which is bought directly from the mutual fund company.
The structure of ETFs make them more tax efficient in general because the actions of one investor do not have an affect on other investors in the fund (you can learn more about this in our Bond ETFs article). However, for bond Index Mutual funds it’s also possible to minimize taxes through prudent portfolio management, to the point where there is generally not a significant difference between the taxes you will pay on a bond index mutual fund vs. a bond ETF which is tracking the same index. For example the Vanguard Total Bond Market Fund had a taxable capital gains distribution of .27% so far for 2012. Vanguard’s ETF version of the fund the BND had a distribution of .24%.
Bottom Line: When comparing Index Bond Mutual Funds to Bond ETFs there is a slight tax advantage to the ETF but generally not enough to make a significant difference in returns.
Bond ETFs trade during market hours the same as a stock. Bond Mutual Funds can only be bought or sold once a day. Because Bond ETFs trade like a stock, their share price can differ from the underlying NAV of the ETF. This can add another level of volatility into the price of a Bond ETF that does not exist with a Bond Mutual fund. You can learn more about this in our article “Why Bond ETFs Do Not Always Track Their NAV.”
Bottom Line: If you are a long term investor then the ability to trade throughout the day should not make a difference. If you are a short term investor, or looking to take advantage of intraday price swings, then the ETF is the clear winner. Differences between the ETF’s share price and the underlying NAV of the fund can add an extra level of volatility, which may give a slight edge to bond mutual funds.
The goal of passively managed bond index funds and ETFs is to track the performance of a specific index as closely as possible. However, as many bonds do not actively trade passive funds normally own a sampling of bonds which is meant to be representative of the bonds held by the index. For this and other reasons the Index Mutual Funds and ETFs do not exactly track the index. This is called tracking error.
Tracking error is going to vary depending on how liquid the market is for the bonds in the index the fund is tracking. Our research has indicated however that there is not a significant difference in tracking error between bond mutual funds and bond ETFs, so this one is a toss up.
What’s the Bottom line?
At the current time actively managed ETFs are still in their infancy. As the majority of bond mutual funds are actively managed, if you want an actively managed fund then the choice is clear: Bond Mutual Funds are better than Bond ETFs.
If you want a passively managed bond fund, then Bond Index Funds and Bond ETFs are very similar creatures for long term investors. Ultimately the decision is going to come down to cost. If you are planning on making frequent small investments then investing in a bond index mutual fund, directly with the mutual fund company (so you do not pay a commission), is likely to save you a substantial amount of money over Bond ETFs. If you are planning to make large infrequent investments then Bond ETFs are likely to offer a slight cost savings vs. index bond mutual funds.
This lesson is part of our Free Guide to the Basics of Investing in Bond Funds. Continue to the next lesson here.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.