Inside a Mutual Fund Evaluating BPRAX

Now that we understand the basics of this fund which I discussed here (BPRAX), let’s take a moment to understand why it is that we would want to consider it as an investment opportunity. I’m going to discuss this fund under the following assumptions:

  • The near-term inflationary environment is uncertain due to the US and EU debt situation, combined with the volatile markets being fuelled by stimulus plans.

  • The near-term predictability of market returns from both debt and equity are uncertain, due to extreme market volatility.

  • The cost of capital for the near term will remain at its relatively low level, with reasonable stability.

  • We are investing with a major aversion to risk.

These three assumptions basically depict an environment in which we are uncertain about our ability to create real returns that will match or outperform both the opportunity-cost of investing in other assets. However, it implies that we have stability in our ability to raise and allocate money, due to government intervention or a stable income.

The final assumption (my personal favourite) is the standard of excellence that I use to ensure that we are protecting the capital of our investments at all costs. By investing with a major risk aversion, we are keeping in mind the goals of the personal investor. Let’s now look at why it is that this fund could be considered to meet these criteria, better even than the out-performing criteria.

Because this fund is indexed against inflation, the first assumption of risk is negated by the nature of the assets in the fund. Regardless of what kind of macro-economic events may arise, the fund is protected against the inflationary environment, and will therefore always provide a relatively stable real return over the short term.

While we can’t predict what will happen to the distributions and NAV over the medium or longer term, as the redeemed funds from bonds are reinvested at different rates, we can keep track of the short term returns with relative ease because of their nature as debt. Real return is therefore predictable and therefore practical for a personal investor.

When examining the issue of performance against other market opportunities, it is important to remember that the overall market today is extremely volatile. As I’ve mentioned in previous articles, it is important to remember what it is your goals are as a personal investor. Given that we are dealing with a Fund of Bonds, this asset would need to be compared against other fixed-income assets of similar class. When examining the kinds of YTM that are being generated by the arguably overbought US bond market, it becomes apparent that this fund certainly manages to out-perform, if only by a small margin.

However, it is also apparent how these funds also provide a greater margin of safety against market volatility. Specifically, normal bonds are greatly exposed to inflation rates. Since this fund hedges against inflation, we can easily see how it is that the fund provides a much higher quality of investment than what a personal investor could pursue in the market by themselves with the same amount of capital.

Lastly, an aversion to risk leads is the final aspect of consideration that leads us to consider this fund as being superior to its benchmarks. This can be discovered when we look at the structuring of the specific ladderings used by the fund and its Barclays counter-part, as well as by examining the resulting statistical metrics from over the last five years.

As discussed before, the Standard Deviation, Sharpe Ratio, and benchmarked Beta of the fund all point towards returns that demonstrate a greater efficiency than the benchmark, while providing less volatility. However, the while nominally underperforming the benchmark, it is still remaining highly competitive over the long-term, meaning that the investor doesn’t give up much for gains by choosing the greater safety of the BlackRock fund.

The general terms of the holdings provide a key insight about the performance of the fund. While the Barclays fund has seen a slightly greater return by holding a larger weighting of longer-term assets, the BlackRock fund maintains its flexibility by more evenly distributing its terms. This further reduces the exposure of the BlackRock fund to shifts in the market, by allowing it to better track the returns of yields. While short-term yields are arguably low right now, they may increase over the mid-term, allowing the BlackRock fund an opportunity to benefit where the Barclays fund cannot.

Combined with a general understanding of how the market-cycle suggests that investors should focus on buying shorter term bonds during times of contraction or trough (sorry guys, but we missed the opportunity to go coupon-camping with long-term bonds), it becomes apparent that the features of the BPRAX fund pass enough of the initial ‘sniff’ tests, affirming that there may be an opportunity to apply this fund towards a personal investing profile as a fixed income asset.