March 30, 2020: How Did Bond ETFs And Mutual Funds Fare In The Current Crisis?

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Wednesday April 1, 2020.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Brokerage Plans Phased Out

For years, we have established various ‘plans’ based on list of ETFs or mutual funds suggested by brokerages. For example, Schwab featured its OneSource mutual fund list to its clients. To accommodate these customers who have accounts in Schwab, we have created public plans like Schwab OneSource Mutual Fund so that these users can follow model portfolios generated from this list of funds.

However, it has come to a point where we now believe most of these brokerage plans are not necessary and we now decide to gradually phase them out. Here are the several reasons:

Too many brokerage plans of ETFs or mutual funds are confusing to users. Many average (basic) subscribers have been frustrated with too many choices and aren’t sure which one to pick for.
We now advocate universal ETFs model portfolios based on MPIQ Core ETFs Asset Allocation Composite Moderate (a user can customize based on his/her own risk profile). These ETFs are either broad base highly liquid stock index ETFs (mostly from Vanguard) or a combination of liquid enough active and index bond ETFs. They can be accessed from any brokerage account. Furthermore, for those who really prefer mutual funds, we advocate using a combination of stock ETFs and total return bond mutual funds such as Stock ETFs And Bond Mutual Funds Moderate Schwab. For those who want to use mutual funds exclusively, since our stock funds are all low cost index funds, we believe users can easily find substitutes in their brokerages.
We also want to avoid legal issues such as using a proprietary Schwab OneSource mutual fund list.
Finally, frankly, those proprietary mutual funds suggested by brokerages don’t really fit to our philosophy: only use ultra low cost stock index funds, ultra low cost bond index funds and some excellent total return bond mutual funds.

Over times, you will find our web pages will not feature these plans/portfolios anymore. However, we will continue to update those existing portfolios but do encourage users to switch to the portfolios listed on Brokerage Investors and Fixed Income Investors pages.

How Did Bond ETFs And Mutual Funds Fare In The Current Crisis?

As financial markets recovered somewhat last week, most issues mentioned in our previous two newsletters were corrected. However, we do want to point out some important issues for bond ETFs, especially for those that are used in our brokerage portfolios.

First of all, for VanEck High Yield Municipal ETF HYD, the big discount between its price and its NAV narrowed last week. But the discount is still very big: as of 3/30/2020, its close price $55.28 is still 7% discount against its NAV 59.24. That’s still too big and unacceptable to a fixed income investor.

What’s more, we want to look at Vanguard Intermediate Term Corp bond ETF VCIT that’s used in our MPIQ Core ETFs portfolios like this one.

The reason behind us choosing this bond ETF in our candidate list is because it mostly invests in investment grade corporate bonds and it’s the most liquid and cheapest bond ETF in the category of intermediate term investment grade corporate bonds.

Unfortunately, the performance of this ETF has been disappointing so far in this crisis:

Portfolio Performance Comparison (as of 3/27/2020):

Ticker/Portfolio Name	1 Week Return*	YTD Return**	1Yr AR	1Yr Sharpe	3Yr AR	5Yr AR	10Yr AR
VCIT (Vanguard Intermediate-Term Corp Bd ETF)	8.9%	-5.8%	2.0%	0.07	3.0%	2.8%	4.8%
IGIB (iShares Intermediate Term Corp)	8.0%	-6.0%	0.3%	-0.09	2.9%	2.4%	3.4%
LQD (iShares iBoxx $ Invst Grade Crp Bond)	14.7%	-4.1%	6.4%	0.33	5.0%	3.7%	5.3%
VFICX (Vanguard Interm-Term Invmt-Grade Inv)	2.9%	-2.3%	3.9%	0.51	3.4%	3.0%	4.5%
BND (Vanguard Total Bond Market ETF)	4.7%	2.6%	6.0%	0.51	2.0%	0.7%	0.8%

3 Month Return Chart

VCIT YTD (Year To Date) return is much worse than VFICX’s. In fact, there were times in previous weeks when VCIT experienced -16.9% maximum drawdown, compared with VFICX’s -9.2%! The ETF did so much worse than the mutual fund that’s supposed to be its equivalent. This certainly created some stirs among some of our subscribers!

Notice that VCIT’s name explicitly does not include any investment grade wordings. However, this ETF is indeed treated as an investment grade bond ETF.

Let’s take a closer look at VCIT portfolio composition (based on Morningstar):

Based on Morningstar, bonds rated BBB and above are deemed to be investment grade. So VCIT does look like only investing in investment grade bonds.

Let’s further look at VFICX portfolio composition (based on Morningstar):

The mutual fund VFICX has so much less exposure to BBB rated bonds (18.6% vs. 56.2%). This is the main reason why the ETF did so much worse than the mutual fund: as we have discussed several times before, many expect a massive downgrade of lower rated investment grade bonds (BBB, for example) to high yield or junk levels (i.e. BB or lower) in a crisis (such as the current one). Thus, not only VCIT’s underlying bonds were hit harder than those in VFICX, the panic spread to VCIT’s price, creating an even bigger loss at one point.

What we can learn from the above (and the current crisis):

ETFs are not necessarily the same as mutual funds. In this case, VCIT has been widely used as an investment grade bond ETF (which, technically, is correct). But it’s very different from the mutual fund (VFICX) in the same category from the same family (Vanguard).
In a crisis or a distressed market, bond ETFs can experience larger loss than their underlying NAVs. This is because of the illiquid bond market. In fact, this even exists in supposedly highly liquid investment grade corporate bond market. Put it another way, other than Treasury bonds, all other bond ETFs can be subject to such a large discount in a crisis.
However, so far (as in 2008-2009), we haven’t observed large price/NAV discounts in broad based stock index ETFs such as VTI or SPY. This is because in stock/equity market, stocks are more liquid and thus it’s easy for market makers to arbitrage away large price/NAV discounts/premiums.

Market overview

Covid-19 discussion

We want to follow up our educated discussions on Covid-19 pandemic as it’s the main cause for the current economy and market chaos.

First off, it’s finally admitted by many country governments that Covid-19 is not a flu (see March 2, 2020: The Risk Of Coronavirus Outbreak). President Trump now even stated that without measures like social distancing and shutting down social places (like restaurants, sports etc.) in serious outbreak areas like New York or California, it’s likely to result in 2 million or so deaths in the US. He now managed down the expectation and claimed that if the US can control the number of deaths to be below 100,000, his administration would have done a good job. This compares with the 12,000 deaths caused in H1N1 influenza in 2009 (see CDC). Such a conclusion could have been deduced many weeks ago: for example, at the time of our March 2 newsletter writing (or even earlier), we knew Covid-19 transmission rate R0 is 2.2 (or between 2-3) and its death rate is around 1%. So in an uncontrolled (i.e. without any measures such as social distancing, that was essentially the situation in the US at that time) environment, it would eventually infect about half to 2/3 of the whole US population (about 300M). That translates to 100 million to 200 million infected. A one percent death rate would mean 1m to 2m deaths. So Trump is essentially saying if we can manage it down to 1/10th of this, that would be good enough.

Death rate aside, as stated in March 16, 2020: A Live Lesson, in addition to slowing down and controlling the virus spread, what’s important is the process or mechanism come up in this phase. Once we manage down the spread (thus the number of infected starts to decline), before the wide range vaccination or an effective cure is finally deployed, such a process will be needed to quickly and effectively contain a small outbreak. We term this phase as phase 4 in our previous newsletter. Currently, we are in phase 3 to contain the spread.

Again, we want to emphasize that it will take several months or so for phase 3 and phase 4 to complete. Economy will not magically recover in a few weeks. Financial markets will experience uneven recovery and loss over times.

Both the Federal Reserve’s monetary measures and the $2 Trillion government fiscal stimulus in this crisis are massive and decisive. They have temporarily stabilized the economy and the markets. Unfortunately the underlying economy is seriously affected and will take time to recover.

Stocks recovered strongly last week. S&P 500 is now less than 20% below its all time high. Stocks are not cheap at all. We expect more volatility ahead.

In times like this, our boiler plate suggestion is the following (just like in the last newsletter):

For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

For more detailed current market trends, please refer to 360° Market Overview.

In terms of investments, stocks are finally getting cheaper. Investors should not be swayed by the current market volatility and economic distress, instead, they should stand ready to take advantage of the opportunities. For most Americans, we offer the following Winston Churchill’s remark made in the darkest days of World War II: “The Americans will always do the right thing, but only after they have tried everything else.” As a country, the US (and the rest of the world) will get over this, as always, even after stumbles.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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