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Buying bonds: Are ETFs or mutual funds the better bet?

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If clients are getting their exposure to fixed income through funds, what should advisors know about the differences between buying in through exchange-traded funds or mutual funds, and are the pros and cons of each affected by rising interest rates?

Advisor Eric Aanes, president and founder of Titus Wealth Management in Larkspur, California, says that he chooses bond funds when rates are rising.

“We’re buying bond funds because it gives great latitude to purchase many different styles,” he says.

Aanes says that it is also important now to look at floating-rate bond funds, and while he knows he can tap into that space through ETFs as well, he feels more comfortable with a fund manager because “securities selection seems to be a great way to add alpha in the fixed-income world.”

He generally favors actively managed funds for high-yield bonds.

“ETFs seem to be much more volatile since they are representative of the index and hold virtually no cash,” Aanes says. “And there are distinct advantages managers can have by altering the duration of the portfolio, meaning that the majority of actively managed funds are of shorter duration.”

Aanes says that Titus Wealth Management has had some bad luck with fixed-income ETFs.

“Because if you think about it, the reason people buy bonds is they want to limit the volatility; they want to have a dampener,” he says. “And we have bonds that are actually positive for the year, so the manager selection piece has been good from that perspective.”

The trade-off is that management fees are higher, but for unconstrained, high-yield and floating-rate funds, Aanes thinks that it is generally worth it. On the other hand, he thinks that higher costs may not make more sense if a client is buying a traditional government bond fund.

“I think it’s harder to add alpha to that,” Aanes says.

ETFs offer many of the same advantages for bonds that they do for equities: lower expenses; tax benefits; transparency, where exact holdings are available instantaneously, rather than at months-long intervals; and trading throughout, not just at the end, of the day.

“If someone wanted that feature of being able to buy and sell intra-day and if that’s important to them, obviously an ETF would provide that,” says Matt Peden, chief investment officer at GuideStone Capital Management in Dallas.

But with bonds, most clients aren’t thinking about that very much, “so it’s not a huge plus,” he says.

Additionally, Peden says that GuideStone Capital Management has concerns about bond ETF liquidity, especially with rising rates.

The rate environment definitely affects the decision of whether to buy a bond fund or an ETF, Aanes says.

“If we felt that we were moving into a period of time where rates were declining, we’d be more interested in buying an ETF,” he says. “But if rates are going up, I’m more inclined to buy actively managed funds, because with the volatility, active managers have more flexibility to decide what to buy.”

Paul Hechinger is a contributing writer to Financial Planning and On Wall Street.

This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.

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