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Is Vanguard's Total Bond Fund Right for Your Portfolio?

Last week, we examined how adding GNMAs and high-yield bonds impacted the risk and return of portfolios and found more efficient alternatives. Today, we'll analyze one of the more popular fixed income investment vehicles: the Vanguard Total Bond Market Index Fund.

The fund has almost $70 billion of assets under management, and as of year-end 2009, it held about:

  • 39 percent of its assets in mortgage-related securities
  • 36 percent in U.S. government bonds
  • 19 percent in corporate bonds
  • 6 percent in foreign bonds (both corporate and government)
When we analyzed GNMAs, we found that they weren't as efficient for portfolios as five-year Treasury bonds. Given the significant allocation to mortgage-related securities in the portfolio, we might expect to see the same result when adding the total bond fund (note the fund also contains corporate bonds, and thus adds credit risk).

Morningstar's database goes back 20 years, so that's our time frame. During the period February 1990 through January 2010:

  • The Vanguard fund returned 7.0 percent with a standard deviation of 5.0 percent.
  • Five-year Treasuries returned 6.7 percent with a standard deviation of 5.9 percent.
As we did last week, we will compare two portfolios that are rebalanced annually, each with an allocation of 60 percent to the S&P 500 Index:
  • Portfolio A will allocate its 40 percent fixed income allocation to Vanguard's fund.
  • Portfolio B invests in five-year Treasuries.
You would think Portfolio A would be the wise choice, since the Vanguard fund produced higher returns with less volatility than did five-year Treasuries. But, the evidence actually shows otherwise:
  • Portfolio A had an annualized return of 8.3 percent with a standard deviation of 12.8 percent and a Sharpe ratio of 0.41.
  • Portfolio B had an annualized return of 8.3 percent with a standard deviation of 12.0 percent and a Sharpe ratio of 0.43.
The two portfolios produced identical returns. However, the portfolio holding the Vanguard fund exhibited 7 percent greater volatility. Thus, it was a less efficient portfolio. The reason is that Portfolio B benefited from the -0.10 annual correlation of five-year Treasuries to the S&P 500. (The correlation of the Vanguard fund to the S&P 500 was 0.21.)

To summarize, this is why it's important to avoid looking at investments in isolation. Even though the Vanguard fund produced better returns than five-year Treasuries, you wouldn't have been rewarded with greater returns, let alone greater risk-adjusted returns. Finally, I think it's important to add the same comment I made about including GNMAs in a portfolio: There are far worse "mistakes" than investing in the Vanguard total bond market fund.

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