A New Vanguard Index Fund Could Lag Active Managers

NEW YORK ( TheStreet ) -- Among the most popular mutual funds last year was Vanguard Total International Bond Index (VTIBX). Launched in June, the index fund now has $18.9 billion in assets. The inflows were particularly notable at a time when many shareholders abandoned bond funds. During the first 11 months of 2013, investors withdrew $73 billion from intermediate-term funds, according to Morningstar.

With its low expense ratio of 0.23%, the Vanguard fund clearly has appeal. If U.S. bonds sink this year, foreign fixed-income markets could offer diversification. But many investors may prefer actively managed global funds instead of the passive Vanguard choice. In the past, active funds have outdone the benchmarks.

During the past five years, the average world bond mutual fund returned 7.3% annually, surpassing the Barclays Capital U.S. Aggregate Bond Index by two percentage points and topping the Citigroup Non-U.S. dollar World Government Bond Index by 3.2 percentage points.

A recent Vanguard study concedes that the returns of many active managers have beaten the benchmarks. The researchers looked at how 275 global bond funds performed during the 10 years ending in 2012. In that decade, 57% of the funds topped the unhedged Barclays Global Aggregate Bond Index.

Why have the active managers excelled? Vanguard says the portfolio managers have increased returns by taking on risk. While the global benchmarks are heavy with high-quality government issues, the active managers sometimes buy low-quality bonds and securities from shaky emerging markets. The strategy has boosted returns in good times, but the riskier approach has sometimes fared poorly in downturns. During the turmoil of 2008, world mutual funds lagged the Barclays U.S. Aggregate by 6.8 percentage points.

The Vanguard index fund could be particularly well-suited for conservative investors because the portfolio focuses on investment-grade bonds in developed markets. In addition, the fund hedges away currency risk.

In contrast, most actively managed global bond funds hold foreign currencies. When foreign currencies decline against the dollar, the value of overseas assets declines for U.S. investors. That has happened in recent months and presented headwinds for most foreign funds. The Vanguard fund has been unscathed because it holds currency forward contracts that do not fluctuate as the value of the dollar moves.

Whether or not the dollar strengthens, chances are good that active global bond funds will outdo passive choices in coming years. If the global economy continues growing, as many economists expect, then low-quality foreign bonds should rise as investors worry less about defaults.

For investors who can tolerate some risk, a solid active fund is Legg Mason BW Global Opportunities (GOBAX). During the past five years, the fund returned 11.2% annually, outdoing 91% of world bond funds. The Legg Mason fund buys bonds of varying credit qualities, seeking unloved securities with attractive yields.

To top the benchmarks, the portfolio managers sometimes take contrarian positions. In 2012, they bought out-of-favor bonds from Portugal, one of Europe's most troubled economies. The move proved on target as investors gained more confidence that the country wouldn't default. "The Portuguese were slowly pulling through the crisis and having some success with labor market reforms," said portfolio manager Richard Lawrence.

The Legg Mason fund has held few assets in Japan where yields have been tiny. Instead, the portfolio has had big stakes in Mexico. The bonds pay relatively rich yields and Mexican exports are strengthening as the U.S. economy grows.

Even if the active funds top the benchmarks, chances are that assets will continue flowing to the Vanguard global fund. Vanguard has been pounding the table for its new fund, saying that international bonds can help diversify portfolios.

To underline the point, Vanguard has added the international bond fund to the portfolios of the company's fast-growing target-date retirement funds, which are popular choices for 401(k) plans and hold more than $150 billion in assets. The international bonds will account for 20% of the fixed-income allocation of the target-date funds. As retirement plans grow, the international bond fund should attract a steady flow of assets.

At the time of publication the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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