Pros and Cons of Core Bond Funds
Core bond funds offer investors a single diversified bond fund product with broad exposure to the investment-grade area of the bond market. They provide participation in several market segments, most notably U.S. Treasuries, mortgage-backed securities, and investment-grade corporate bonds. They are also designed to provide a full range of maturities—short, intermediate, and long—in each area. "Core" fund is a relatively new term—many bond funds in this category have changed their names to include the word “core”.
Active vs. Passive Funds
Core bond funds can either be active, which means that the managers frequently change the portfolio’s makeup to capture opportunities or avoid risk, or passive, which means they track an index. An essential difference between the two is that active managers attempt to achieve better than average market results, while passive funds simply try to match the return of the corresponding index—that is, to do no worse (or better) than the average. The relative advantages and disadvantages of active vs. passive funds are not widely agreed upon—each investment type has its advocates and detractors.
Bond index funds, although not carrying the “core” label, can, in fact, represent an appropriate single bond investment for many investors. Funds that track an investment-grade bond index such as the Barclays Aggregate Index have several advantages, including broad diversification, low management expenses, and the certainty that the fund will not suffer extreme underperformance in a given year due to a manager’s bad decisions. At the same time, however, some index funds may have a higher weighting in government bonds and consequently a relatively high sensitivity to interest rate movements.
As noted, by definition they are unlikely to do better than average.
Be aware that not every issuer views the concept of “core” in the same way—the word has no fixed or generally agreed upon meaning. A core fund issued by one company may look much different than a core fund issued by another. In addition, active managers can take a wide range of approaches—with varying degrees of success. In addition, certain funds will adopt more of a “go-anywhere” approach that incorporates high yield bonds or other investments not held in the investment grade indices. Since there is so much variability within the category, it pays to investigate each fund closely to see what it actually holds, how it has performed over time, and how it has held up during market downturns.
In short, don’t assume on the basis of the name alone that a core bond fund meets your objectives.
Another issue with core funds is that most don’t hold weightings in international, emerging market, or high yield bonds. As a result, core bond funds may not necessarily provide the level of diversification that investors expect. Also, since investments in international and emerging market segments tend to have lower exposure to interest rate movements than a typical core fund with significant holdings in Treasuries and corporate bonds, a core fund may have greater exposure to interest rate risk than a fully diversified portfolio.
An investor who wants to achieve total diversification may consider supplementing their core funds with high yield and/or international funds.
How to Invest
Investors have a choice between mutual funds or exchange-traded funds (ETFs). Mutual funds can be purchased directly from the company or through a broker, while ETFs require a brokerage account. Two of the largest core bond mutual funds are PIMCO Total Return Fund (ticker: PPTDX), DoubleLine Total Return Fund (DLTNX), while three of the most well-known ETFs are Vanguard Total Bond Market ETF (BND) and iShares Core Total U.S. Bond Market ETF (AGG), and PIMCO Total Return ETF (BOND). As always, when making an investment in a fund or ETF, consider the particular fund's management fees.
Robust research in this area concludes that management fees are a significant factor affecting long-term profits. There is also evidence that an inverse relation exists between management fees and fund performance—the most expensively managed funds underperform the sector average while funds with the lowest fees outperform the average.