Over the last couple of weeks I’ve written a series of articles about stock market indexes and the various exchange-traded fund alternatives to those indexes. While those instruments were almost exclusively equity-related, today’s article will deal with bonds, a very important but neglected component of any investment portfolio.
Larry MacDonald, a Canadian economist and author, puts index investing into its simplest form by utilizing just two ETFs — one for bonds and the other for equities. I won’t get into the details of his One-Minute Portfolio, but it has been remarkably successful. The truth is, we could all use a little fixed income in our investment diet. Read on and I’ll explain how to replicate the bond portion of the One-Minute Portfolio.
MacDonald’s two ETFS are the iShares S&P/TSX 60 Index Fund (TSX:XIU), which replicates the largest 60 stocks by market cap on the Toronto Stock Exchange. The U.S. version of this would be the Dow Jones Industrial Average. For the bond portion, he uses the iShares DEX Universe Bond Index Fund (TSX:XBB), which replicates the performance of the DEX Universe Bond Index.
That index is a broad measure of the Canadian investment-grade fixed income market, with approximately 1,100 securities that are invested in Government of Canada bonds, provincial bonds, municipal bonds and corporate bonds. Approximately 46% of the holdings are in Government of Canada bonds, which, last time I looked, are a very safe investment. Since the focus of this article is bonds, the equity suggestion for a U.S. version of the One-Minute Portfolio is the SPDR Dow Jones Industrial Average ETF (NYSE:DIA), which I discussed on Jan. 26.
Moving on to the heart of the matter, we need to find a U.S. replacement for the DEX Universe Bond Index. Originally I was going to go with the Barclays Capital U.S. Aggregate Bond Index, but that includes mortgage-backed securities, and the DEX Universe Bond Index does not. The index that most closely resembles the DEX Universe Bond Index is the Barclays Capital U.S. Government/Credit Index, with 52% in U.S. Treasuries, 18.6% in other government-related issues and the remaining 29.1% in corporate bonds. The average duration (maturity date in years) is 5.98 years, versus 6.27 for its Canadian counterpart. It’s as close as we’re going to get, so now we can now figure out the ETF alternatives.
There’s really only one. Sure, there are some variations on the theme, but if you want something broad-based without the worries that mortgage-backed securities can potentially represent, the iShares Barclays Capital U.S. Government/Credit Bond Fund (NYSE:GBF) is your go-to here. With an expense ratio of 0.20%, it’s two basis points lower than the iShares Barclays Capital U.S. Aggregate Bond Fund (NYSE:AGG). In terms of assets under administration, there’s no contest — the iShares Barclays Capital U.S. Aggregate Bond Fund has $14.6 billion, versus just $136.5 million for the iShares Barclays Capital U.S. Government/Credit Bond Fund.
But popularity hasn’t translated into better performance. Over the past five years, the smaller fund has achieved an after-tax return of 5.34% through Jan. 31, versus 4.98% for the much bigger fund. Simpler is often the better way to go.
The bottom line: If you were 40 years old on January 31, 2007, and invested $40,000 in the GBF and $60,000 in the DIA, five years later that $100,000 would be worth $123,619. That’s a pre-tax annual return of 4.3% — 170 basis points higher than if you’d invested the entire amount in the equity fund. The One-Minute Portfolio really works.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.