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How much of your bond fund is actually in stocks?

(MoneyWatch) It may surprise you that, as of its last reporting date, there were 352 mutual funds that are classified by Morningstar as bond funds that actually held stocks in their portfolio. (I know I was surprised, and given my 40 years of experience in the investment banking and financial advisory business, it takes quite a bit to surprise me.) At the end of 2012, it was 312, up from 283 nine months earlier.

The chase for higher yields has led many actively managed bond funds to load up on riskier investments, such as preferred stocks. The result is that investors in these funds now own portfolios with very different risks than they had intended to take. And the risks of these investments tend to show up at exactly the wrong time, as in 2008, when you need your bonds to provide protection because the risky assets in your portfolio have suffered large losses.

The academic literature makes clear that the vast majority of the risk and expected return of a portfolio is determined by its asset allocation, or exposure to factors that explain returns. Among these factors are stock market risk, the risk of small stocks, the risks of value stocks, momentum, profitability, term risk and default risk. Since your portfolio's risk is determined by these factors, it's critical that you be able to control your exposure to them. Failing to do so can result in your portfolio being exposed to more risk than you have the ability, willingness or need to take. And when risks inevitably show up, investors who have taken too much risk are often driven to panic selling and commit what I refer to as "portfolio suicide" -- once you sell you're virtually doomed to fail because there is never an "all clear" signal that will let you know it's safe to invest again.

Having complete control over your portfolio's risk is one of the major benefits of passive investing. On the other hand, active investing entails taking the risk known as "style drift" -- the risk that active fund managers will change the fund's exposure to asset classes and factors. The following is a great example of the dangers of style drift.

The Wall Street Journal recently noted that the Forward Income Builder fund (AIAAX), run by Forward Management LLC, had 49 percent of its assets in stocks at the end of February. Not even one year prior, the fund had almost no money in stocks. Imagine you were building a $100,000 portfolio and needed to split it between 60 percent in stocks and 40 percent in bonds. If you put all your bond portion into AIAAX, you would actually have only 20.4 percent in bonds, meaning you would be taking far more risk than you originally wanted.

Style drift also allows active managers to play games when measuring their performance against benchmarks. For example, "of the 325 funds that Morningstar says specify a 'prospectus benchmark' against which they say they should be judged, 313 funds compare themselves against a bond-only benchmark." Owning riskier assets than the benchmark and then showing outperformance is inappropriate. Unfortunately, performing such analysis is beyond many (if not most) investors, meaning they won't know how true the outperformance being touted actually is.

When you couple these facts with the poor performance of actively managed bond funds, that makes the case for using only low-cost, passively managed bond funds, or an individually tailored bond ladder, all the more compelling.

Image courtesy of Flickr user 401(K) 2013.

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