Good Bond Funds at the Wrong Time

Analysts say bond funds may deliver weak long-term returns to investors buying at the top of the market.
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NEW YORK (TheStreet) -- In recent years, investors have been dumping stock funds and pouring tens of billions of dollars into PIMCO Total Return (PTTAX) - Get Report, the giant bond fund run by acclaimed manager Bill Gross.

Are the investors making a mistake? Probably, said speakers at the recent

Morningstar Investment Conference

in Chicago. While PIMCO Total Return is a great fund, shareholders are buying at a time when fixed-income yields are small and many analysts worry that bond funds could deliver weak long-term returns.

The situation at the PIMCO fund is hardly unique, speakers warned. "People are buying good funds, but they are buying at the wrong times," said Don Phillips, Morningstar's managing director.

Over the past several decades, investors have become smarter fund shoppers, Phillips said. In the 1980s, the most popular funds came with high expenses and indifferent returns. The list of the largest fund families in 1986 included

Dean Witter

and

E.F. Hutton

, companies that used armies of brokers to push expensive funds.

Today the best-selling funds are from fund families with reasonable expenses and solid performance, including

Vanguard Group

,

Franklin Resources

(BEN) - Get Report

, and

T. Rowe Price Group

(TROW) - Get Report

. Most brokers focus on selling funds with strong records. "Assets have flown to funds that really have merit," Phillips said.

But despite their growing sophistication, millions of investors have continued to chase the hottest performers. All too often investors buy near market peaks, when hot funds are delivering strong returns. Then the funds turn down. Many investors get disgusted with the results and sell near market troughs.

With technology stocks soaring in the late 1990s, many shareholders sold bond funds and bought stock funds near the peak. That proved to be a mistake. In the decade that began in 2000, bond funds returned 7% annually, while stock funds stagnated. Last year, investors sold stock funds and bought bond funds. As a result, investors missed the huge rally that began in March 2009.

For an idea of how much investors can lose when they chase hot funds, consider Morningstar's data on fund total returns and investor returns. The familiar total returns show how much you would have gotten if you invested in a fund and stayed there for a certain period, such as 10 years. Investor returns indicate how much average shareholders actually got. In instances where investors bought at peaks and sold at troughs, the investor returns can be lower than total returns.

For the average fund, the investor return is 1.63 percentage point lower than the total return. In some fund categories, the results are even worse. During the 10 years ending in June, the investor return for the average midgrowth fund showed an annual loss of 2.4%, which is 1.8 percentage point worse than the total return. For midvalue funds, the investor return trailed the total return by more than 3 percentage points. "The amount that investors lose because of poor timing is greater than the cost of expense ratios," said Karen Dolan, Morningstar's director of fund analysis.

Phillips blamed part of the problem on companies that promote hot funds at market peaks. But not all companies encourage short-term thinking. Phillips cited Vanguard as a company that warns investors away from hot funds. To prevent investors from buying at peaks, Vanguard shuts funds or puts up barriers. After it avoided big losses in the market downturn,

Vanguard Market Neutral

(VMNFX) - Get Report

could have become a popular fund, Phillips said. But Vanguard limited inflows by requiring minimum initial investments of $250,000.

Phillips also cited

American Funds New World

(NEWFX) - Get Report

as an example of an emerging markets fund designed to promote sensible behavior by investors. The fund was launched in 1999, a year when emerging markets were recovering from the Asian financial crisis and investors were shunning the category. Shareholders who bought then tended to be patient investors with long time horizons.

To cushion investors in downturns, American Funds New World often holds cash and some steady blue chips, such as

America Movil

(AMX) - Get Report

, a big provider of wireless phone service in Latin America, and

Teva Pharmaceutical

(TEVA) - Get Report

, an Israeli maker of generic drugs.

Because the fund's investors are protected from big losses in bear markets, they are more inclined to hold until the market recovers. That can enable the average shareholders to get strong long-term returns.

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Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.