UPDATE: Don't expect short-term bond funds to keep up with inflation
By John Coumarianos
There's been no lack of stories about investors ditching actively managed stock funds for index funds lately. Besides avoiding managers who can't beat the index, stock indexers benefit from tax efficiency, thanks to minimal trading by index funds, and low expenses.
Expenses are a massive detriment to compounding. If you give up one percentage point of, say, a pre-expense 7% annualized return to fees, that can cost you big over time. For example, over a 35-year period of investing $5,000 per year, that levy translates to a $127,000 haircut to the future value of your investment ($605,000 versus $478,000), in rounded numbers.
What observers haven't noticed as much, however, is how high expenses are on actively managed short-term bond funds, relative to the paltry return they're poised to deliver.
Not long ago, investors with liquidity needs two or three years away could hold a short-term bond fund in lieu of cash, and expect to match inflation after fees.
The chart below shows how the Morningstar short-term bond fund category, on average, performed versus inflation (measured by the CPI) over the decade through the end of 2014. On a compounded annual basis, the category average returned 3.49%, while inflation ran at 3.54%. The average fund nearly matched inflation, despite a terrible 2008, in which many funds paid dearly for dabbling in subprime mortgages.
Short-term bond funds are generally composed of relatively high-quality (2008 notwithstanding) corporate, mortgage, and government bonds maturing relatively quickly (two or three years).
But the lower yields associated with higher quality, relatively fast-maturing bonds didn't prevent the funds from providing healthy returns for the past decade. In fact, if the fund had only cut their expenses by five basis points annualized, the average fund would have matched inflation.