Pop the Hood!

Just as all car engines are not alike, neither are investment vehicles — the subtle details of a mutual fund’s investment style can drastically alter its performance.  Investors can expose themselves to the wrong risks if they don’t “pop the hood” and understand how the vehicle works.

Currency hedging in international bond funds is a great example. Some funds do it and some don’t. It can make a big difference in a fund’s performance. And you can’t necessarily count on basic analytic tools, like Morningstar, to properly identify a detail like this.

Two funds, nearly identical performance

Here is a real-world example. An investor was wondering about the differences in behavior between the DFA 5 Year Global Fixed Income Fund  and the Vanguard Short Term Corporate Bond Fund. They sound like very different funds, don’t they?

Actually, I told him, they will be virtually identical. Below is a graph of their performance and, as you can see, the DFA and Vanguard funds basically mirror each other.

Bond chart

How can this be?

The DFA Global Fixed Income is a fund of short term, high grade, global bonds. It also uses a currency hedge, so it behaves like a bond denominated in US dollars.

The Vanguard Short Term Corporate is a fund of short term, high grade, US corporate bonds.

When you break it down that way, both funds have:

  1. Similar duration (short term)
  2. Similar credit quality (high grade)
  3. Similar currency risk (US dollars).

The end result is two funds that perform basically the same.

The “a-ha” moment

Now, here is where an investor could be led astray. The DFA 5 year Global Fixed Income is categorized by Morningstar as “World Bond.” Why? Simple, it owns a lot of foreign bonds. Morningstar’s basic categories aren’t detailed enough to pick up on the currency hedging aspect. The funds gets thrown into a peer category with all sorts of other world bond funds that are not currency hedged, and will therefore fluctuate greatly with the currency markets. This, in turn, completely messes up any quantitative analysis that compares this fund with its “category peers.”

Real-world impact

This is just one example of why basic fund analysis doesn’t always tell the whole story. You need to “pop the hood” to really understand what is going on under the surface of a fund before putting it in a portfolio.

Unfortunately, too many families have to learn this the hard way.  Investors in the Oregon 529 College Savings Plan had a lot of their “conservative” money in the Oppenheimer Core Bond Fund, which took massive losses in 2008. It was a conservative fund. It had a lot of bonds, although there were also a lot of credit default derivatives and some mortgage bonds — a subtle, yet important detail.

Like a car motor that emits a small, yet ominous noise when you turn on the ignition, it’s the hidden risks of investing that are often the most dangerous.

Photo by Rajiv Vishwa