The Secrets of Investing – Bond Funds and Diversification
Are Bond Funds Good?
Last week we covered the first part of this interview on mutual funds, now let’s pick up where we left off. Today we will discuss bond funds, diversification, and whether they’re a good investment strategy.
So now, the flip side, bond funds. As much as there are inefficiencies in the mutual fund market, the bond funds are probably even more inefficient. So do you want to talk a little bit about that too?
Absolutely. The bond market is very inefficient, especially versus the equity market or the stock market. And the reason for that is because there are just so many different issuances of different bonds that are out there.
If you look at the stock market as a whole there are about 5,000 stocks. Now 5,000 stocks may seem like a lot, but each particular company really only has one common stock to it.
Now flip that over to the bond side, and each of these companies can have 10 or 20 different issuances of bonds. And then you compound that with the fact that there’s also a whole municipal bond market that is constantly issuing debt each and every year. So now there are many different issuances in many different structures within the bond market.
The sheer size of the bond market creates inefficiencies. However, those inefficiencies also create opportunities for those who understand the correlation.
So because of the sheer size of it, it creates inefficiencies. However, what inefficiencies create is an opportunity, because if you can understand the correlations or the pricing of one security versus another, then all of a sudden you can see when something is kind of trading out of whack and that’s what is creating the opportunity.
Going back to what we do versus what bond funds do is it kind of goes back to what we were discussing with the prospectus. The bond funds, once again, have to invest in bonds by the prospectus. They can only be buying certain securities that are already outlined. But there could be a specific issue, a certain structured issue that may not have even been around when the prospectus was first made for that bond fund.
This is how we are different. If it’s got value, we can go in there and invest in it. So being able to be flexible like that allows us to take advantage of opportunities, number on.
But secondly, within the fixed income realm, is that a lot of times some of these issuances that come out are small in size. So they may be very attractive, but if they’re only issuing a million of these. So $1.5 million for a fund that maybe has $65 trillion in assets, it’s not even a drop in the bucket for them. So they don’t even get involved with some of these smaller issuances on the bond side because it’s just not impactful for them even if they are allowed to buy them by prospectus.
For us, that’s a perfect size. We’ll take some of those because we have client accounts that can use them and we’ll allocate them out accordingly.
So it’s kind of a couple of those dynamics of why the bond market is so inefficient. Although it does provide those opportunities if you are the right size and are able to be relatively nimble.
Should I Buy Bonds?
You also have the experience. If you don’t have the experience and don’t have the size, it’s not possible to take advantage of these opportunities. Even if an advisor could see the opportunity, if they have to buy it on the trading desk then they end up paying a markup cost for the bond, and then it loses its luster, so to speak. Where you have the ability to get it without paying that big markup, is that better?
Yeah, absolutely. So that is one reason why other advisors aren’t doing this. Part of it speaks to the experience. A lot of other advisors out there don’t have members of the team that had back experience on municipal bond writing desks. Being over on that side of the world, the institutional side of the investment world is where they start to understand the spreads and the trade opportunities because that’s how they would interact with large institutions.
We had some individuals from that side that came to our team and they’re now bringing that institutional bond world over to what’s quote-unquote, the retail space, but it’s really for individual investors. They saw that there was no one else out there doing it, so there’s an inherent need for it. And to your point, we can bypass trading desks at the different custodians through what’s called a prime brokerage.
That’s something we always get set up on our client accounts, but then that’s what allows us to not have to buy the bonds through the bond trading desk at a TD Ameritrade or Schwab. We can actually go out and buy them wholesale in a block from the actual dealer and then allocate them accordingly to our client accounts, bypassing the markups.
Am I Diversified With Bonds & Mutual Funds?
That’s why we have you! And that’s why we have the team behind you! We’re looking at all four aspects of your financial life and make sure everything’s coordinated for our clients. This means to do that well, we don’t have the time or all the experience in bonds. For an advisor to really do this, you have to have a good collaboration. You have to have a team and have that experience behind you.
The reason most accounts are not managed like this is that it is more labor-intensive for the advisors.
There’s another reason I think a lot of advisors or managers don’t do it, it’s because it’s more work, if I’m being candid. For an advisor, or a manager that puts together a portfolio and changes an ETF or mutual fund every now and then versus what you guys are doing, there’s a big difference, Right? What you’re doing is a lot more labor-intensive. It’s why most managers aren’t doing it. Would you agree?
Yeah, absolutely. It is more labor-intensive like you said. There’s a lot more thought process that has to go into it. So it’s, it’s not only the thought process on the selection side, but then it’s a whole other aspect of the actual execution side of things and that’s for both stocks and bonds.
So that means you have to have individuals on your team where that is their primary focus. You know, they can’t be focusing on anything other than following specific securities in their set sectors so that they can be executed timely.
The perfect example is if you don’t have that team built around you and people are wearing multiple hats, talking with clients, going out of the office a lot, etc. You can’t possibly execute efficiently or with individual stocks and bonds. That is why for advisors, the way to fill that is by using ETFs and mutual funds, which theoretically should be hopefully doing that management side for them (but as we have talked about, there are many inefficiencies with this model).
We’ve invested in the infrastructure because we know if we can get that working efficiently there’s so much value add it can add for our clients by actually utilizing the individual securities.
It’s easier for an advisor to put it in a fund and get a management fee and be done with it. Although, they’re really not doing a lot for the management fee versus what you.
I love that with you, there are no hidden fees because you’re using the individual stocks or bonds. But what you’re doing, you’re actually continuing to work day in and day out, you’re really managing it.
I think it’s important that if you’re paying a management fee, you want to know what the people are doing. That’s why we built out the team with you guys too. I know that you’re looking at it continues to do something and not just taking the easy way out.
Absolutely. We love that structure because it’s very transparent when a client can pull up their account and you see the actual positions that they’re holding and you see the actual trades that may have happened.
Then it becomes a much better discussion, especially in times of volatile markets, because then we can talk about the thought process or the rationale for why we are holding this. Why were we selling that? You don’t get that on the mutual fund because all you see is a mutual fund that’s either going up or down in value.
Yeah. I think that that’s good too. I’ve said, if someone’s managing your account they should be able to tell you what they’re doing and why. If they can’t give you an answer or explain it, then what are we paying them for?
If you have questions on this or want to know more on how all this works or what Guy is doing right now with the portfolios or take a deeper dive on yours to explore some opportunities, then let’s talk.
Make sure you give us a call and we’ll schedule it to do a review. Guy, I always say this to everyone but one of the things that I love is you’re not like so many of the other managers whose advice is often, everything you have is bad, come to us, we can do better.
Your whole philosophy is to keep the winners and get rid of the losers, meaning build around what you have but making sure you keep what’s performing well. It’s not like selling everything and making it all completely different. I appreciate that about your team.
Yes, absolutely. I think that’s a very important factor.
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