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Dimensional Bond Funds—Doing What They Are Supposed to Do

Old World Map

What is the proper role of bond indexes in a diversified portfolio?

IFA's advice is that bonds perform two vital functions. First, they dampen the volatility of the stock indexes which in turn facilitates the adjustment of the overall risk exposure to match the investor’s risk capacity.

Second, they provide a source of liquidity so that investors do not have to sell stock indexes at a loss (unless they are tax loss harvesting, of course) or realize short term or even long term capital gains. While other advisors may talk about providing “safe income” that eliminates the need to “dip into principal”, we conclude that bonds are not a good place to reach for extra return or yield. Risk is most highly rewarded in stock indexes, and therefore, that is where investors should take most of their risk. Since investors have a risk budget, if they choose riskier bond indexes, they must reduce their exposure to stock indexes. The chart below will illustrate this concept:

Given these two purposes of bonds, the appropriate characteristics for bond indexes include high quality ratings and short term durations of 5 years or less. The four Dimensional bond funds that IFA currently utilizes to implement its index portfolios meet these requirements. Two of those funds are designated as global bond funds, meaning that they include bonds issued in both the United States and in international developed countries. What distinguishes them from most other global bond funds is that they are low cost, hedge away currency risk and they are very diversified. This means that they have a similar level of volatility to other domestic bond funds of similar quality and duration, and in some cases, they have achieved a higher return relative to other funds by taking advantage of steeper yield curves in other countries.

Now and then, we receive questions about the Morningstar ratings of the Dimensional global bond funds which are currently rated one and two stars for the Two-Year Global and Five-Year Global, resepctively. Aside from questioning the general utility of the star rating system, our answer is that these particular star ratings are based on a mis-categorization of those funds.  Specifically, Morningstar classifies them as “world bond” funds, which means that they are being compared to funds that take on unhedged currency risk, not to mention possibly taking on higher term and default risk. Instead, they should be compared to short-term domestic fixed income funds to reflect their hedging away of currency risk.

To see whether the DFA bond funds are accomplishing their task of maximizing return for the low level of risk, we prepared the charts below which show the funds compared to other existing funds in their Morningstar category. The charts show that no funds have achieved a higher return at the same level of risk and very few got the same return at a lower level of risk, even for the global bond funds when compared to funds that do not hedge currency risk. But the opposite is true. There were many funds that exposed their investors to much greater risk and yet acheived same or lower returns. The term we use to describe the performance of the DFA bond funds is “efficient”.

 

 

As the charts above show, the DFA bond funds have done an excellent job in making trade-offs between risk and return. As we continue to emphasize, the goal of bond indexes should not be to maximize returns in general but to maximize returns within a risk budget. We conclude that the Dimensional bond funds have done exactly that, so we currently use Dimensional bond funds in the implementation the IFA Index Portfolios.