Beyond The Cost Of AGG & BND

December 14, 2011

The aggregate bond ETF world is full of funds that track the same index, and yet investors aren't focusing on cost alone. Is that wise?

 

(This is an updated version of a blog that appeared previously. The charts in the earlier version don't appear in this new version.)

 

Investors considering the Vanguard Total Bond Market ETF (NYSEArca: BND), the iShares Barclays Aggregate Bond Fund (NYSEArca: AGG), the Schwab U.S Aggregate Bond ETF (NYSEArca: SCHZ) and the SPDR Barclays Capital Aggregate Bond ETF (NYSEArca: LAG) may look at the index descriptions of the various funds and wonder: Why would I choose anything but the cheapest fund in the group?

After all, the funds track the same index. They should all provide the same performance, right?

Well, not necessarily. Bond funds are an entirely different animal than their equity brethren.

The indexes they track often have thousands of constituents, many of which are either highly illiquid or impossible to find altogether. Furthermore, some fund managers will own bonds that aren't included in the index but whose return and duration characteristics are deemed similar to those included in the index.

The benchmark for these four funds, the Barclays Capital U.S. Aggregate Index, is a great example of this. The index has 7,854 bonds, many of which are either hard to secure or highly illiquid. It's nearly impossible to fully replicate the index, and anyone attempting to do so would have such a high expense ratio that a few basis points of better tracking would be a drop in the bucket.

So all of the funds optimize—holding some, but not all, of the securities in the index, in an attempt to match the index's overall return. And while optimization is a necessary evil—from a tracking perspective—it's employed to varying degrees. So, a quick analysis is in order.

Optimization By Degree: From SCHZ To BND

On one extreme of the optimization scale you have SCHZ, which holds only 414 bonds. That's just 5 percent of the securities in the Barclays Index. At the other extreme is BND, which holds 4,991 issues, or upward of two-thirds of the credits in the index. Then there are the middleweights, LAG and AGG, which hold 603 and 1,260 securities, respectively.

Ultimately it's up to individual investors to decide how much optimization they are willing to stomach, and at what tracking cost. In the case of SCHZ, you get a segment-best expense ratio at just 10 basis points, but you also get the most aggressive optimization strategy.

Is 1 basis point—the difference in price between BND and SCHZ—enough to justify owning 58 percent less of the underlying index? If so, SCHZ is a fine choice for investors looking to shed costs.

That said, a closer look at the relative returns of each fund paints an entirely different picture.

The table below shows the number of holdings for each fund, the percentage of the benchmark they are optimizing, and each fund's expense ratio. On the right, it shows what the total return was for each fund, and how that compared to the total return of the index over the same period of time. Expected returns of each of the funds, all else equal, are the returns of the index minus each fund's expense ratio.

 

Ticker #
of
Holdings
Replication Expense
Ratio
Total Return
NAV
Index Return -
Expenses
For The Period
Performance
Vs.
Expected Return
AGG 1,260 16.04% 0.22% 3.72% 3.70% 0.01%
BND 4,991 63.55% 0.11% 3.85% 3.75% 0.10%
LAG 603 7.68% 0.17% 3.80% 3.72% 0.08%
SCHZ 414 5.27% 0.10% 3.65% 3.75% -0.10%
Index 7,854 N/A N/A 3.80% N/A N/A

 

Does it matter?

 

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