Stocks versus Bonds, Part 2

Stocks versus Bonds, Part 2

June 30, 2012

The May 2012 edition of the Morningstar EFTInvestor newsletter (written by Paul Justice, CFA, Director of North American ETF Research for Morningstar) contained some interesting comments about the percentage of investment assets going to stocks and bonds.

The article begins by noting the continuing investor preference for bonds relative to stocks.
According to the article, combined investment flows into Exchange Traded Funds (ETFs) and mutual funds this year equaled a net $225 billion invested in bonds while $83 billion was withdrawn from stocks (equities).

Year-to-date (May 2012) investments into mutual funds and ETFs by asset class
Mutual funds

Source: Morningstar EFTInvestor, May 2012, page 1.

One possible reason he mentions is “the fantastic performance of bonds relative to stocks during the past decade.”

Justice goes on to say: “To me, these figures are staggering. When bonds go up relative to equities, as they have for a full decade, asset allocation tells us we should sell bonds and buy stocks. What we are witnessing is a full-blown retreat from risky assets and into perceived stability.

…With interest rates remaining near all-time lows, what good can possible come from all this interest in fixed income? I understand that stocks may seem scary, but bonds can underperform, too.”

Justice also manages ETF portfolios for Morningstar. Some time ago he positioned his portfolios to protect against rising interest rates (which cause prices of existing bonds to decline). He did this by “neglecting” US Treasuries and keeping duration “rather short.”

He knew this would hurt portfolio performance if rates continued to decline or stayed low. Rates actually declined so intermediate and long-term Treasuries outperformed. Justice estimates that it cost his portfolios 1% of performance per year over the last three years.

Well, let’s be honest. Or at least let me be honest. One reason I like the article is that it mirrors my recommendations to my investment clients. My recommended portfolios contain no Treasury or long-term bond mutual funds or ETFs. These will suffer if interest rates rise and it seems more likely that interest rates will rise than continue to fall. In addition, with interest rates low, bond investors earn little income to compensate for the risk of a decline.

The risk/reward ration does not favor long-term bonds and US Treasuries. Of course, that doesn’t mean that they won’t do well in the future. As low as interest rates are, they could still go lower.

For a previous post on stocks versus bonds, scroll down to "Why Invest in Stocks," posted May 9, 2012.