Most investors don't have to be convinced of the merits of exchange-traded funds. These investments are typically cheaper than actively managed mutual funds, are generally more tax-efficient, and offer greater trading flexibility.
While stock funds still account for the majority of ETF assets, an increasing number of bond ETFs are also available to investors. But hiding among all these fund options are a handful of funds that may not be appropriate for many folks. Let's take a look at some bond ETFs that you might want to avoid right now.
Now taking bets
Even if we ignore the fact that the bond market's best days are likely behind it in the current market cycle, there is one corner of the ETF market that investors would always do well to pass over: leveraged funds. These funds usually offer double or triple the daily return of the fixed-income benchmark the fund is tracking. I don't think there's any legitimate reason why investors need to own a leveraged ETF. These funds are often used in an attempt to make a quick buck betting on the short-term direction of the market
Some of the funds in this space that you should avoid include Direxion Daily 20+ Year Treasury Bull 3X Shares (NYSE: TMF ) , Direxion Daily 7-10 Year Treasury Bull 3X Shares (NYSE: TYD ) , and PowerShares DB 3X Long 25+ Year Treasury Bond (NYSE: LBND ) . The two Direxion funds offer three times the daily return of their respective indices, while the PowerShares fund provides three times the monthly return of its benchmark. And while the Direxion 20+ fund has posted an astonishing 52.8% year-to-date gain (and has a really cool ticker symbol!), it wouldn't take much to rack up losses of that magnitude once rates start to rise.
Additionally, these funds are closer in price to your typical actively managed fund than the average exchange-traded fund. The two Direxion funds have a 0.97% expense ratio, according to Morningstar data, while the PowerShares fund clocks in at 0.95%. That's just too much for an ETF, especially if it's basically gambling on the market.
The long and short of it
Given that interest rates really have nowhere to go but up, investors need to be aware that when interest rates rise, bond prices fall. Longer-term bonds are especially at risk here, since bondholders are locked into lower rates for longer periods of time. That means investors need to pay attention to the average duration of their bond funds.
Short-term bond funds will be the least affected by rising interest rates, since these bonds can be rolled over into newer, higher-yielding securities more quickly as they mature. Intermediate-term funds will lose some value as rates rise. But in a few years, the fund should more than make up that lost ground, as the higher interest payments offset any losses from selling lower-yielding securities. It's harder to make a case for leaning heavily into long-term bonds right now, since they will be the most sensitive to rising rates, and fall in value the most when that occurs.
With that in mind, three bond ETFs that investors might want to avoid in today's environment include the Vanguard Long-Term Government Bond Index (VGLT), SPDR Barclays Capital Long Term Treasury (NYSE: TLO ) , and iShares Barclays 20+ Year Treasury Bond (NYSE: TLT ) . Unlike the leveraged bond ETFs above, I don't think there's anything inherently wrong with any of these funds, and in other situations they might be fine investments. I just don't think they are appropriate in today's economic environment, given their durations between 13 and 16 years.
Of course, if you were truly bearish on the U.S. economy and think rates will be kept low for years and years to come, it might make sense to buy long-duration bonds at today's rates. I'm not predicting a robust, high-growth recovery, but I don't think rates are going to stay this low for years on end, so sticking to more intermediate-term securities probably makes sense.
And a few to grow on
In contrast, there are several bond ETFs that would be fine choices for a wide range of bond investors. Two of my favorites here include Vanguard Total Bond Market ETF (NYSE: BND ) and iShares Barclays Aggregate Bond (NYSE: AGG ) . These funds come with low annual expenses of 0.12% and 0.24%, respectively. Both funds offer exposure to wide-ranging segments of the bond market including Treasury bonds, mortgage securities, corporates, and foreign bonds. Their durations of around four years make them less sensitive to interest rates. These all-weather vehicles are appropriate for conservative and aggressive investors alike, in varying amounts.
Bond ETFs can be a great addition to any portfolio, but investors need to make sure they stick with broad-market, inexpensive funds and avoid some of the newer, trendy options. And while bonds may not return as much down the road as they have in recent history, they should remain an important part of every investor's asset allocation plan.