Wall Street for Dummies Dec 20, 2024

Lewis Carrol’s Alice in Wonderland begins with Alice following an anthropomorphic rabbit down a rabbit hole. Alice then follows the rabbit until she comes to a fork in the road, where she finds a Cheshire cat sitting in a tree. She asks the cat “Which road should I take?” He replies. “If you don’t know where you are going, any road will get you there.”

At the risk of sounding like a one trick pony, this brings me back to the curve at the end of a straightaway thing. The response I have been hyping is to move assets from the stock market into the bond market. But before doing so, you must answer the Chesire cats’ question; “Where are you going? You may be looking for protection from a market downturn or you may be approaching retirement and searching for income. For the moment, let’s put the income search on the back burner.

The only alternative individual investors have is bond funds, and not individual bonds. Unfortunately, the index fund revolution that has provided 100 million individual investors with reasonably priced returns in the stock market, has not infected the bond market. According to Morning Star, 73% of US bond funds are actively managed. That means only 27% are passive funds or ETFs.

In order to measure their relative performance and tout their expertise, active bond funds mangers use the Bloomberg Aggregate Bond Index (AGG). It contains a bodacious mix of high grade, low grade and no grade bonds. Fund managers love it because it is much easier to beat then the primary stock indexes.

Individual investors who accept AGG as the benchmark for quality will likely be lead down a path that is contrary to their goal of protection from a market down turn. If you truly are seeking safety, you want to stick to government bond funds. Be aware that they have a lower yield, but are less volatile than the AGG index.

After Alice her cat chit chat, the cat’s body disappears and all that is left is the cat’s broad gleaming smile. I take this strange twist of events as an allegory for Wall Street’s carnivorous bond fund managers. According to Morningstar, bond funds expense ratios range between 80 and 120 basis points. In a low-interest rate environment, that’s a big chunk out of the funds dividend yield.

I didn't finish reading Alice-in-Wonderland, so I don't know how it ends. What I do know is that unless you paying attention to the curve at the end of the straightaway, you may end up where Yogi Berra predicted, “Somewhere else.”

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