Which is Better: Mutual Funds or CDs?

by Larry Swedroe, 7/19/19

When investing in equities, mutual funds are generally the preferred choice over individual securities because of the need to broadly diversify and to minimize idiosyncratic (and therefore uncompensated) risk. On the other hand, with fixed income investments that do not take on credit risk (such as Treasury securities), there is no need to diversify credit risk. Thus, investors can build individual portfolios of securities, avoiding a fund’s expense ratio. And for taxable bonds, FDIC-insured CDs typically offer considerably higher yields than the similar risk-free Treasury securities of the same maturity (which can also be purchased individually, avoiding a fund’s expense ratio.)

For example, as I write this on June 15, 2019, a five-year secondary market CD (which trades just like bonds and has daily liquidity) yielded 2.65%, or 0.80 percentage points more than the 1.85% yield on the five-year Treasury note. And at times, primary CDs offer even higher yields. They lack daily liquidity and typically come with penalties for early withdrawal. However, if rates do rise significantly, it can be advantageous to pay the early withdrawal penalty and reinvest at the higher rates versus facing the full markdown that would occur on a Treasury issue or a secondary CD. Investors can find CDs that mature in as long as 10 years. For example, the current yield on a secondary 10-year CD is 2.85%.

For investors in 401(k) and 529 plans, in which one doesn’t have the ability to invest in CDs, mutual funds must be used. At Buckingham Strategic Wealth, our recommended choice of funds for such constrained investors is the DFA Five-Year Global Fixed-Income Fund (DFGBX), which has an expense ratio of 0.27%. The fund uses a variable maturity approach (based on their research showing the term premium is greatest when the yield curve is steep) and takes a small amount of credit risk as well, investing in high-quality, short-term corporate debt (Morningstar shows that currently 91% of its holdings are rated AA or higher and just 9% are rated A). The fund shifts holdings around the globe based on the highest yield available for a given maturity after hedging for currency risk. The maximum maturity of the fund is five years (which will occur when the curve is steep), and the maturity will shorten when the curve is flatter. Using Portfolio Visualizer’s backtest portfolio tool, from January 1991 through April 2019, DFGBX returned 5.13% with a standard deviation (SD) of 2.8. This compares favorably with the performance of the five-year Treasury note of the period. Its return and SD were very similar – 5.25% and 4.2%, respectively. DFGBX provided a very similar return while taking slightly less risk in terms of volatility. This is why we prefer the fund to one that has a constant maturity and holds only U.S. Treasury securities. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

Using data from Dimensional, the following table provides further evidence that DFGBX has performed well over the past 20 years, providing modestly higher returns with modestly higher volatility, than similar indexes. As you review the results, keep in mind that indexes have no costs, but implementing a strategy in a live fund does. And those costs are not limited to a fund’s expense ratio.

Summary Statistics, February 1999-December 2018

Returns Hedged to USD	FTSE World Government Bond Index 1-5 Years	Global 1-5 Year Gov. and AAA/AA-Corp. Index	Five-Year Global Fixed Income Portfolio
Annualized Compound Return (%)	3.20	3.34	3.72
Annualized Standard Deviation	1.31	1.34	2.57

However, for investors who do have access to individual CDs, as one does in self-directed tax-advantaged accounts, the significantly higher yields favor the holding of CDs.

The advantage in terms of higher yields provided by CDs is time varying. At times of crises and flights to quality, when Treasury securities are in high demand (depressing their yield), the spread tends to widen and vice versa. Thus, one should not assume that today’s yields are reflective of what the advantage will always be. However, given the relatively low volatility of a five-year maturity (which balances the dual risks of inflation and reinvestment), even when spreads are half of what they are today, the advantage is worth considering.

Finally, while DFGBX has the advantage of being able to shift maturities daily, investors in CDs can also shift maturities (though in a more limited way) by building a bond ladder that reflects the current steepness of the curve. When individual CDs mature, they can extend maturities further when the curve is steeper and shorten them when it is flatter. Investors could use a rule of thumb such as extending them another year when the incremental return is 20 basis points. That said, I urge caution in taking a shifting maturity approach to an extreme because, in doing so, you lose the balance between the twin risks of inflation and reinvestment. Thus, investors could consider targeting an average maturity of five years and be willing to extend perhaps to as long as six years and as short as four years. The decision should be based on the individual investor’s exposure to the risks of inflation and reinvestment.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

Which is Better: Mutual Funds or CDs?

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