Last week, I posted a request for blog readers to submit ideas for future blog topics. Thanks to those who took the time to do so!

One of the recurring themes was a desire to receive more commentary on fixed-income investing (in general) and our bond-fund recommendations (in particular). Admittedly, our writing is mostly stock-market oriented. That's where the interest is greatest among the majority of our readers. But that doesn't mean we can't do a better job in 2015 talking about the fixed-income side. And we will.

To lay the foundation for that, it might be helpful to review the history of SMI's bond-fund recommendations. For most of the 1990s, we applied an Upgrading approach to selecting our bond funds just as we did with stock funds. In 1999, I looked back on the results and concluded they were not much different than simply using an indexing approach. In May of that year, I added index options for each of the bond categories but continued to also make recommendations based on Upgrading for those willing to invest the extra time.

Looking at bond-fund performance again in late 2002, I decided to change to relying primarily on indexing for our bond categories. The reason for that is it’s very difficult for a manager to distinguish himself managing bonds. In stock funds, the gap between the top and bottom fund in a category might be the difference between doubling your money and cutting it in half. In bond funds, it’s usually a percentage point or two.

When it comes right down to it, who you have managing your bond fund matters a whole lot less than how much you’re paying them to manage it. A skillful stock manager can overcome high expenses with good stock selection, but rarely is that the case in the bond arena. It’s much more likely that whatever edge a skillful bond manager might gain is gobbled up by high expenses.

If expenses are the critical element in selecting good bond funds, you would expect the lowest-cost providers—index funds—to have a significant performance edge, and indeed they do. In the research I did at that time, only 11% of funds in both the short-term and long-term categories were able to beat their comparable index fund over the previous five years. And only 4% of intermediate term funds did so.

The raw numbers were striking: 40 of 45 long-term funds, 84 of 94 short-term funds, and a stunning 175 of 183 intermediate-term funds failed to keep pace. This isn’t so surprising when you realize that the average bond fund charged 1.25% in expenses, while the Vanguard bond index funds charged only 0.21%.

While SMI’s bond recommendations (using Upgrading) did reasonably well compared to the average fund in each group, they nevertheless lagged the corresponding Vanguard index fund in all three categories. So rather than stick with an Upgrading methodology that required more effort on our readers' part and yet was less productive, I took an “if you can’t beat ‘em, join ‘em” approach. Beginning in 2003, we stopped selecting actively-managed funds for our bond investing and recommended Vanguard’s index funds instead.

That was our approach for 11 years, from 2003 through 2013. However, as you know, we made a partial turn away from index funds in January of this year. We replaced two of them with the Scout funds with a view to the coming rising-rate environment as explained in the January issue:
For some time, we've been educating SMI readers to understand that when interest rates start rising, it's a mathematical fact that bond prices will fall in response. (In an environment of rising rates, short-term bonds are hurt less than long-term ones.) We got our first taste of that last May/June [2013] when the Fed hinted it would begin "tapering" (i.e., slowly reducing) its Quantitative Easing purchases, and the bond market immediately registered significant losses. We expect that once it begins, an upward trend in interest rates will last for several (likely many) years. As a result, we think it's appropriate to change how we deal with bond-market risk. Indexing performs best during strong bull markets, such as the one bonds have experienced for the past 30 years. But indexing has a significant downside: there's no way the fund manager can play defense when a bear market arrives. That's why we're shifting part of our bond allocations away from index funds and back to active-management.... The days of bonds being boring and simply producing a decent income stream are over. The Scout bond funds have had bigger short-term swings than SMI readers are used to.... This expectation of occasional volatility represents a change from our old way of thinking about bonds.... [However] we're confident these changes will help us better navigate the bond market in the years to come, but it's crucial you understand the potential risks and rewards of these new tools.
We did discuss the first-half performance of the Scout funds in the August issue:
Both of the two new Scout bond fund recommendations are run by managers who believe that significant volatility in the bond market surfaces more often than most investors recognize. They view these periodic bouts of volatility as opportunities, buying at discounts when other investors are temporarily panicking. However, with volatility holding near all-time lows during the first half of 2014, these Scout funds have been positioned extremely defensively, which is their default posture between periods of opportunity/volatility. The fact that interest rates have moved in an unexpected—and difficult to explain—manner for six months has done little to shake our conviction that this change in recommendations is still likely the correct decision.
At this point, nothing has changed in our expectation that interest rates will eventually rise; however, readers with a different perspective who wish to take a less cautious stance are free to use our earlier bond-index ETF recommendations.