YOUR MONEY : FUNDS AND 401(K)S / Chet Currier : When Skipping Funds to Buy Bonds Directly May Be the Better Choice

One of the unheralded skills of a good mutual fund investor is knowing when not to invest in mutual funds.

Whatever your goals, you may be able to better realize them by investing directly in the securities markets instead of a fund.

Take bonds and bond mutual funds. The bigger an investment in bond funds grows, the more reason you have to consider switching that money into individual bonds.

Many financial advisors have long preached that you need a stake of about $100,000 to put together a bond portfolio on your own with decent diversification.

Now, a study says that even with $50,000 it’s worth doing the homework to see whether you’d be better off going the direct route.

“Our analysis suggests that you can build a diversified portfolio of bonds with a $50,000 investment at estimated costs that are equal or better than that charged by low-cost bond funds,” said the authors of the study, James Peterson and Vinay Singh of Charles Schwab Corp.’s Center for Investment Research.

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In practice, the trade-offs between funds and direct investing vary widely from one type of bond to another. At one extreme, you can invest as little as $1,000 directly in U.S. Treasury securities at virtually no expense by bypassing brokers and buying from your nearest Federal Reserve bank or branch.

At the other extreme, creating your own portfolio of high-risk corporate junk bonds might require much more than $50,000 and demand constant vigilance.

In all cases, your best choice--bonds or bond funds--may depend on factors other than costs. For instance, if you want an investment with a set maturity date or with a fixed yield, a bond provides both. An open-end mutual fund provides neither.

Conversely, if you want the easiest vehicle for moving money in and out of bonds at short notice, funds may be the logical place to look.

Assuming a 10-year investment period for its study, Schwab compared the costs of investing $50,000 in bond funds charging management fees of between 0.15% and 0.20% a year against the costs of creating packages of five individual $10,000 bond investments with “laddered” maturities of two, four, six, eight and 10 years.

Using its own estimates of commission expenses and dealer markups on bond transactions, it figured the cost for individual Treasury bonds at 0.13% of assets per year, or $65, against 0.15% per year, or $75, for the lowest-cost Treasury mutual fund that Schwab sells via its fund “supermarket.” For investment-grade corporate bonds, the study put the annual cost at 0.11% of assets per year, or $55, compared with 0.20%, or $100, for a low-cost corporate fund.

But for investment-grade municipal bonds, Schwab’s estimate of annual direct-investing costs, at 0.21% of assets, or $105, was slightly higher than the 0.19% fee, or $95, charged by the lowest-cost municipal bond fund.

Note that the fund estimates are for the cheapest funds. Many bond fund investors pay much more.

Costs aside, if you’re using bond funds for certain purposes, you might find that individual bonds would be better.

Say you’re interested in preserving capital for college tuition payments beginning five years from now. When the tuition bill comes due, an individual bond maturing at that time will provide an amount that can be known in advance. The market value of the bond may vary in the interim, but at maturity you know what you’ll get.

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By contrast, for many investors “the biggest problem with bond mutual funds is no fixed maturity,” said Sheldon Jacobs, publisher of the No-Load Fund Investor newsletter in Irvington-on-Hudson, N.Y.

The bonds in a fund will change as the manager buys and sells. And if market interest rates rise over the next five years, your bond fund principal value may well decline.

But the funds offer other advantages. They allow you to automatically reinvest interest income in additional fund shares. They offer maximum diversification. And fund shares are simple to sell, should that be necessary. Individual bonds can be much tougher to unload.

Bond or bond funds? As your fund investment portfolio grows, it’s worth at least weighing the pros and cons.