PHOENIX — Almost every client investment portfolio holds shares of bond funds to hedge against other investments’ poor performance, provide income, and preserve capital. What’s the best way to choose bond funds and explain those choices and their performance to clients?

Carefully, and with insight, says Venk Reddy, chief investment officer at Zeo Capital Advisers. As they work to ensure that not one risk overwhelms a portfolio, Reddy speaking at NAPFA's spring conference says, advisers must choose: active or passive management? The question is something of a red herring, he asserts. “It’s not about active versus passive,” he says. “It’s about value for money. What are you paying for, and are you getting what you’re paying for?”

Every fund has an expense ratio, Reddy notes — even passively managed funds. “Passive management is something of a misnomer,” he says. “There’s some activity that has to take place in order to track an index. When an exchange-traded fund has a lot of money flowing in, its managers issue an OWIC, or offer wanted in competition. Similarly, when money leaves a fund, managers issue a BWIC, or bid wanted in competition. The money has to get to work quickly,” he says.

The OWIC/BWIC system has unintended consequences, Reddy says. “The more people use ETFs to get fixed-income exposure, the more the benchmarks get pushed around by fund flows more than by underlying value.”

To choose the best bond funds, then, planners need to calculate fund flows bids and offers. “Multiply the bid/offer by the fund flow, and you get a percentage of assets under management. Do the same calculation every day and you’ll see how much it cost to trade these fund flowers. You’ll find out that passive investments aren’t always lower cost.”

What’s more, Reddy says, “you get more friction costs as you go up in both credit and duration” — places where actively managed fund managers often look for increased performance.

Active management makes a difference in other ways as well. “Being disciplined about when you enter a trade and how much you pay matters to a bond fund’s performance,” Reddy says. “Active funds also look at smaller bonds that don’t often show up on ETFs’ radar screens, and that can mean better yields. The credits you pick matter as much as when you pick them,” he says.

Unfortunately, it’s not easy to explain this to clients, who tend to think about investing in terms more suitable to equities than bonds. “Most reporting systems are made for equities,” he says. “They’re made to show cash return. So client reports only show price return, not total return. It’s important to educate clients around total return,” Reddy says, and explain the statements that clients see.

A trader in the 10-year Treasury note futures pit of the Chicago Board of Trade. Image: Bloomberg

Reddy suggests planners:

• Start with client and portfolio goals and time frames.

• Align measurement and metrics with goals.

• Evaluate success over appropriate time periods.

• Diversify into underrepresented exposures.

• Focus on value for money.

• Avoid looking at fixed income through an equity lens.

“Remember,” he says, “for most fixed-income investors, the primary goal is still capital preservation.”