Folks have been lighting up my inbox with questions and comments about an Advisor Perspectives pieceby Michael Edesess (link included for the three of you who may not have seen the piece … you three may also not be aware that Miley Cyrus appeared on the MTV Video Music Awards … link not included). The article is critical of DFA’s recent work on profitability. I’ll focus most of my comments on the contents of Edesess’s section entitled “How the DFA argument is flawed.”
Last week, I outlined how to construct a portfolio of stocks and high-quality bonds to replicate the returns of high-yield corporate bonds. This week I’m tackling investment-grade corporate bonds.The same basic logic as last week holds: There’s not much unique about investment-grade corporate bonds that you can’t achieve with a diversified portfolio of stocks and high-quality bonds. The only difference is you don’t need as much in stocks to replicate the returns of investment-grade corporate bonds as you do with high-yield corporate bonds. This is because high-yield corporate bonds are more similar to stocks because they both have substantial exposure to default risk. Investment-grade corporate bonds have less default risk and therefore aren’t as similar to stocks.
With interest rates at low levels for a number of years now, many investors have moved some portion of their high-quality bond portfolios to higher-yielding investments like high-yield corporate bonds. I’ve long argued that there’s not much these strategies add relative to a traditional stock fund and high-quality bond strategy. Further, the traditional stock fund and high-quality bond allocation strategy tends to have lower costs and be more tax efficient. This is a bit of a qualitative argument though, and I wanted to illustrate the point quantitatively.