Shareholders of the Pimco Total Return bond mutual fund have had every reason to feel smug about their investment choice over the last three years.
The Newport Beach-based fund, the world’s largest in the bond category, has produced handsome returns averaging 10% to 11% a year since mid-2000, depending on which share class an investor owns.
But anyone putting new money into the fund based on its recent performance should pause at least long enough to look at the $72-billion portfolio’s current interest yield.
According to Pimco’s Web site, the annualized yield is 2.5% on the fund’s Class-A shares and 1.9% on the Class-B shares, using the yield calculation that mutual funds are required to show based on Securities and Exchange Commission rules.
Those are far higher returns than the 0.64% annualized yield on the average money market mutual fund. But investors who think they can still reap interest returns exceeding, say, 5% a year on bond funds may be shocked by what they actually get.
The problem isn’t just that market interest rates in general are near 45-year lows. There’s another weight dragging bond fund yields lower: the sum that is deducted from a fund’s gross interest earnings to pay the costs of managing the portfolio.
Investors have long been advised to pay close attention to mutual fund management fees, but it isn’t a topic that generates much excitement. If people brag about their fund choices, it’s usually because their recent returns have been stellar -- not because they’ve been impressed by their fund manager’s penny-pinching.
But over time, penny-pinching managers can add a lot to their shareholders’ bottom lines. That is one of Vanguard Group’s principal marketing pitches and a key reason it’s the second-largest U.S. fund organization.
For the rest of the industry, however, management fees are pretty much the least favorite topic of discussion.
That’s partly why Rep. Richard H. Baker (R-La.) this month introduced legislation to require funds to disclose fee information that would be “more complete and useful” to average investors.
Reasonable people can debate whether the fund industry’s fees are fair or excessive. This is a business that, by and large, has kept its nose clean for 60 years and has provided Americans with a simple way to own a piece of diversified portfolios of stocks, bonds and money market instruments. It must earn a profit to keep going, so there are bound to be fees involved.
Judged by the averages, the fees in the bond fund business may not appear to be terribly onerous at first glance. The average fund that buys intermediate-term bonds (securities maturing in four to 10 years, a popular range with small investors) had an expense ratio of 0.73% in 2002, according to fund tracker Morningstar Inc. in Chicago.
The expense ratio is the percentage of assets that a fund takes directly out of the portfolio each year to pay management costs, including marketing. It’s invisible to shareholders in that they don’t write a check to pay that bill. But pay it they do.
The problem for bond fund shareholders, and perhaps for the industry’s long-term health, is that the decline in interest rates since 2000 means expenses now are eating a large chunk of the gross interest earnings the funds are generating.
When 10-year Treasury notes were yielding 11% in 1985, an expense ratio of 0.73% took away about one-fifteenth of the income from a bond fund sporting that gross yield. As recently as 2000, 10-year T-notes were yielding 6%; at that yield, a 0.73% expense ratio would have taken about one-eighth of interest income.
Now, the 10-year T-note yields 3.54%. If their fund earns that average yield, shareholders who pay a 0.73% expense ratio are giving up more than one-fifth of interest income to fund fees.
It’s a simple matter for bond fund owners to see how much interest they’re sacrificing.
In the case of Pimco Total Return, which Morningstar classifies as an intermediate-term fund, the annual expense ratio is 0.90% for Class-A shares, which are sold with an upfront sales charge of 4.5%, and 1.65% for Class-B shares, which don’t have an upfront charge but assess higher annual fees.
What’s left after fees are the interest yields that funds quote. So another way to think about fund fees is that, if you could reduce them, you could add that net savings directly to your yield.
The issue of fund expenses has become critical for many low-yielding money market funds. It was worsened last week after the Federal Reserve cut its benchmark interest rate by a quarter-point, to 1%. About 200 money funds will be forced to reduce or eliminate management fees to keep their yields even barely positive, according to data firm ImoneyNet Inc.
Bond funds aren’t yet facing a situation that dire. “But if rates stay low or go lower, the problem creeps across the spectrum” of income-oriented funds, said Don Cassidy, analyst at fund tracker Lipper Inc. in Denver.
The historic drop in interest rates “is shining a very bright light on the basic structural weaknesses of bond funds,” said Roy Weitz, founder of Fundalarm.com of Tarzana, a fund watchdog Web site.
Not surprisingly, most fund firms aren’t interested in discussing whether they might, or should, reduce their fees. Pimco said Friday that no executive was available to address the subject.
Fund shareholders may be figuring that the double-digit returns many bond funds have posted over the last few years are the norm. But those big numbers have resulted in part from the appreciation of older, higher-yielding bonds in fund portfolios, which automatically rise in value as market rates slide.
If long-term rates continue to fall, bond funds would reap additional capital gains. But if rates stay in their current range for an extended period, investors’ bond fund returns would depend almost entirely on the net interest paid after fees are deducted.
If market rates rise, interest payments from bond funds also would rise, in time. But the downside would be that the prices of older bonds in fund portfolios would depreciate, which would depress fund share prices. So a fund’s “total return” -- interest earnings plus or minus principal change -- could easily turn negative, as happened in 1994 when rates surged.
Even if bond fund yields stay paltry, many investors may argue that interest earnings are just one reason to own the funds. Bonds also provide relative stability in a portfolio, compared with stocks. And short of owning individual bonds, funds may make sense for people who need the benefit of diversification.
But with interest rates at generational lows, and with bond fund fees taking a bigger share of that interest, it behooves investors at least to know how much income they’re giving up -- and whether they could do better in a fund that charges less for the same basic product.
Tom Petruno can be reached at firstname.lastname@example.org.