Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition

Chapter 7. On Bonds: Treadmill to Oblivion?

Bond mutual funds can fill a useful role. They make it possible for investors to gain the extraordinary value of broad diversification over as many as 100 bonds (or more), reducing risk without an attendant sacrifice in gross return. Bond funds are professionally managed, and most emphasize high-quality, investment-grade bonds in their portfolios. Many offer a particular range of maturities, from short (one to three years) to long (10 to 20 years or more), with gradations in between, enabling investors to balance their income requirements with their tolerance for risk. Bond funds provide considerable flexibility to investors by facilitating purchases and liquidations of shares in small amounts. Some bond funds offer these important advantages at reasonable cost. Most, however, do not. Partly as a result, the once-flourishing bond fund segment of the mutual fund industry has lost much of its attraction for investors.

The rise and decline of the bond fund empire is one of the most captivating, yet untold, chapters in the annals of the mutual fund industry. That story reminds us that the mutual fund principles of diversification and management—as valid today as they have ever been—cannot provide acceptable returns to investors when they are offset by excessive cost encumbrances. It also provides a picture of the complacency and overreaching characteristic of many managers of fixed-income funds.

Surprising as it may seem, as recently as 1993, ...