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3 Ways to Stabilize Your Portfolio with Bond ETFs

3 Ways to Stabilize Your Portfolio with Bond ETFs
Ron DeLegge, Editor
March 13, 2009

SAN DIEGO ( Ė Has your IRA, 401(k) or investment portfolio been clawed? Then join the club of millions of others who have seen their financial plans disintegrate. What went wrong?

A bear market in stocks and real estate happened. And bear markets have the ugly habit of exploiting poorly constructed portfolios. How?

People with over-exposure to individual stocks or single asset classes usually donít notice a problem until its too late. Termites will eat your house to the ground, but you canít see them. And today, the problem of under-diversified portfolios is illustrated everywhere. Just look at the heart-broken millions that overleveraged on residential real estate, incorrectly believing the party would never end. Those that gambled too much of their money on stocks have experienced similar pain. What about you?

One way to stabilize your investments in these unstable times is to have market exposure to bonds.

In 2008 major stock benchmarks like the Dow Jones Industrial Average (NYSEArca: DIA), S&P 500 (NYSEArca: SPY), and DJ Wilshire Total Stock Market Index (NYSEArca: TMW) fell between 30% to 40%. In contrast, the total bond market grew around 5%. Broadly diversified bond indexes have been a safe haven.

Build on a Strong Foundation
Not all bond funds are created alike. And a devastating fall in the performance by broadly diversified bond funds illustrates this point.

Take for example, the Oppenheimer Core Bond A (Nasdaq: OPIGX) which crumbled 35.83% in 2008. Over the same time period the Barclays Aggregate Bond Index climbed by around 5%. What does it mean?

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It means that you should trust the indexes, not the portfolio managers that try to beat them and fail. Building the bond portion of your portfolio with low cost bond index funds is where you should start. Funds that match this description include the iShares Barclays Aggregate Bond Index Fund (NYSEArca: AGG), SPDR Barclays Aggregate Bond ETF (NYSEArca: LAG) and the Vanguard Total Bond Market ETF (NYSEArca: BND).

Donít Chase Yields
Professional and novice investors have lost money trying to make money with bonds. One mistake is investing in higher yielding risky bonds.

ďDonít get greedy by taking on too much risk in your bond portfolio, for the simple reason that it defeats the stabilization purpose,Ē states author of How a Second Grader Beats Wall Street (2009 Wiley), Allan S. Roth, CFP. 

Roth, an investment advisor with Wealth Logic in Colorado Springs, CO, observes that investors are especially inclined to take higher bond risk by chasing higher yields when interest rates are low. He advises not to do it. ďA second grader knows not to lend money to someone who may not pay him back, though we adults seem to forget that all of the time.Ē

Keep Fees Low
There are two components of a bond fundís return: Price appreciation of the bonds within the fund and the income generated from the bonds. Even when you add up both of these things, the expected returns on bonds are lower compared to other asset classes like stocks. What does it mean?

Think about it. If your expected returns from a bond mutual fund are going to be lower versus a stock or commodity fund, it behooves you to keep your fund expenses as low as possible. Simply put, if you pay more you are virtually guaranteed to get less. No where is this undying truth more evident than with bond funds, where historical long-term returns have failed to match stocks.

Whatís the cost difference between bond mutual funds and bond ETFs?

According to Morningstar, intermediate-term investment grade bond mutual funds charge average annual expenses of 0.98%. How do corresponding bond ETFs compare?

ETFguide.comís database shows the category average cost for all intermediate-term investment grade bond ETFs to be just 0.17% annually Ė which translates into a substantial cost savings for any investors smart enough to notice. The typical bond mutual fund investor is paying over 5 times more, but are they really getting 5 times better performance? Probably not. 

Look at your investments. Do you have adequate exposure to bonds?

If not, use low cost bond ETFs to stabilize the fixed income portion of your portfolio. 

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