Many advisors have turned to short-term fixed income with the expectation that bond yields will move higher.
Are clients gaining short-term bond exposure through mutual funds? If so, they could be paying their advisor to lose money.
The persistence of low interest rates has baffled professional investors. Unprecedented Federal Reserve intervention has disrupted the business cycle.
As a result, advisors need to rethink the way that they build fixed-income portfolios.
Don’t use mainstream headlines to shape a client’s investment strategy. For example, allocating to short-term bonds is reasonable, but clients should own longer-dated bonds to generate income.
Investing in short-term bonds has been a poor trade, due to rates remaining lower for longer. Investors have lost out on years of additional interest income.
Investors must understand their all-in cost of investing.
The average traditional wealth management fee is about 1.02%, according to research firm AdvisoryHQ.
Add in the average bond mutual fund expense ratio of 0.65%, and clients would need to generate a 1.67% return just to break even. By comparison, the U.S. 1-3 Year Credit Bond Index has a current yield of about 1.60%.
Racking up fees and expenses within a fixed-income allocation is the equivalent of running a marathon with one’s shoes tied together.
Investors should also beware of floating-rate funds that distribute more income if rates increase. The downfall is that the underlying companies are typically lower quality.
Increasing the cost of capital for a marginal business doesn’t often end well. Punting rate risk and introducing credit risk within a portfolio isn’t a sound strategy.
Instead, use individual bonds or low-cost exchange-traded funds, because when rates are low, every percentage point matters.
Give clients a reasonable opportunity for a positive return, net of fees and expenses.
Advisors who use short-term bond mutual funds are unnecessarily exposing clients to capital loss through fees and expenses. The paradigm shift of low rates demands a new fixed-income approach.
Adopting sound portfolio construction principles for clients can increase the chances of meeting their financial objectives.
This story is part of a 30-30 series on building a better portfolio.
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