Unless the mutual fund is a load fund (which should be avoided because they add expenses without adding value) investors can buy and sell shares at the net asset value (NAV), where there is no bid-offer spread, and buying and selling is done at the same price. When the transaction is made directly with the fund sponsor it can generally be done without incurring any transactions costs. It also allows for the ease of reinvestment of dividends, distributions, and interest.

Another benefit of investing through mutual funds is the ability to trade relatively small amounts ($5,000 or $10,000) in order to generate cash for spending or in the portfolio rebalancing process. This may be especially important for bonds.

The most important benefit of mutual funds is allowing investors to achieve broad diversification across an asset class at a lower cost than investors could do on their own. Broad diversification is important when the performance of a single security within the asset class has a relatively low correlation to the performance of the asset class itself. This is certainly the case with stocks.

For example, the performance of any one stock within the S&P 500 Index might be dramatically different than the performance of the entire index itself. The only way to ensure that you earn the return of the asset class is to own the entire asset class. There is a great deal of academic research on the subject of how much diversification is needed to keep tracking error—the variance between the performance of the entire asset class to the performance of a subset of the asset class—to an acceptable level. To keep it to an expected level of 5 percent (a level some investors would find unacceptably large), an investor would have to own approximately one hundred different individual stocks. And this is true only for the asset class of U.S. large-cap stocks. For asset classes such as small-cap stocks and international stocks a far greater number of individual stocks would be required. Building a globally diversified portfolio across eight to ten equity asset classes is well beyond the resources of almost all individual investors. Thus, mutual funds are the preferred choice when it comes to equities. The issue of diversification is quite different with fixed-income securities.

To begin with, investors limiting their holdings to Treasury securities have no need to diversify credit risk and can ensure themselves of wholesale prices by buying and selling via the Treasury direct program. In addition, there is a great deal of transparency of pricing of Treasury securities since prices are available on at least a daily basis in financial publications such as the Wall Street Journal. This helps keep pricing "honest." Since there is no evidence that managers are likely to add value by correctly forecasting interest rates and adjusting maturities accordingly, the only value a fund might add is convenience. That convenience can be purchased relatively cheaply through low cost vehicles like those offered by Vanguard or ETFs. Whether or not that cost is worth the convenience is an individual decision.

The diversification benefits funds provide becomes apparent once we move beyond the world of Treasuries. To evaluate the benefits of diversification, we must understand the source of the vast majority of returns of fixed-income assets.

Most returns of high-credit-quality, fixed-income securities are derived from interest-rate risk, which is the same for all securities, substantially reducing the benefits of and need for diversification. With U.S. government debt, the need for diversification is nonexistent: 100 percent of the risk is interest-rate risk that cannot be diversified away.

For bonds of the highest investment grades (securities of the U.S. Agencies and the Government Sponsored Enterprises) the need for diversification doesn't change much. There is little credit risk. With other AAA-rated bonds, especially AAA-rated municipal bonds, the need for diversification increases, but to a much lower degree than is the case with stocks. Think of bonds of the highest investment grades as commodities. Bonds of the same maturity and same high credit quality are good, but not perfect, substitutes for each other. While it would not be prudent to build a portfolio by selecting a small sample of stocks from one asset class, prudent diversification can be accomplished with a relatively small sample of very high credit quality bonds. The reason? You can have a high degree of confidence that the relatively small sample will produce returns similar to those produced by the entire population of similarly rated bonds of the same maturity. The higher the credit quality, the higher the confidence and less important any diversification. Conversely, the lower the credit quality, the more important the need for diversification of fixed-income assets. For example, junk bonds are not good substitutes for one another: Two junk bonds are far less likely to provide similar returns than two AAA-rated bonds. Investors seeking the higher expected returns that junk bonds provide should do so through a mutual fund owning several hundred different bonds.

Investors who limit themselves to bonds of the highest quality with a portfolio of perhaps $500,000 should consider building their own portfolio, saving mutual fund costs. A $500,000 portfolio allows investors to purchase securities in large enough blocks that they can limit the markups/downs to acceptable levels, diversifying the credit risk across perhaps as many as ten issuers. Owning that number of securities also allows for the diversification of maturity risk. This could be accomplished by buying one bond maturing in each of the next ten years.

Mutual funds buy and sells large blocks and so are able to minimize markups/downs and minimize trading costs. It is unlikely that individuals acting on their own can obtain institutional prices. Do-it-yourself investors with a $500,000 or larger portfolio should limit themselves to buying in the new-issue market where they can be assured they are getting institutional pricing. They should also only buy individual bonds if they are virtually certain they will be able to hold the bonds to maturity. An investor's trading costs for buying and selling in the secondary market could more than offset a fund's expense ratio. Individuals should avoid doing so on their own, unless they wish to make their broker rich.

While owning mutual funds provides advantages, there are advantages to owning individual securities. First, investors avoid operating expenses of the fund. Second, for taxable accounts, mutual fund investors can only tax loss harvest—have Uncle Sam share the pain—at the fund level. An investor owning individual bonds can manage taxes at the individual security level, providing more loss harvest opportunities. This is especially important with bond funds. Unlike equities, there are no fixed-income funds with the stated objective of tax managing their portfolios, harvesting losses along the way. In addition, while mutual funds can use realized losses, they cannot pass through to investors realized losses not offset by gains.

With Treasury bonds, where pricing is transparent and investors can deal directly with the Treasury, trading costs of tax loss harvesting would be low. When it comes to municipal and corporate bonds, investors trying to trade on their own would probably find any tax benefit from harvesting losses offset by the bid-offer spread, the dealer markdowns incurred when harvesting the losses, and the potential markup paid on the repurchase of a similar bond (unless the investor waited until a new issue was available).

Another benefit of owning individual bonds is that investors can take 100 percent control over the credit and maturity risks of their portfolio. This is generally not the case with mutual funds. They can also control the timing of cash flows from their portfolio. This is particularly important to investors relying on their fixed-income assets to provide the cash flow they need to maintain their desired lifestyle.

Individual investors wishing to take advantage of the benefits of owning individual securities don't have to go it alone. They can use a separate account manager. A separate account manager builds a portfolio of individual securities tailored to the specific needs of the investor. The investor receives the benefits of owning individual securities without having to pay retail prices on transactions. The separate account manager should have access to the wholesale markets and be managing a large amount of assets to provide the maximum benefit to individual investors. We will examine why this is important.

A separate account manager can aggregate the purchases of different investors seeking to buy similar bonds. The following example will illustrate how investors can benefit from this process. A broker-dealer might offer to sell a block of $100,000 of a particular municipal or corporate bond at a price of 102. If the trade was for a block of $250,000, the offer might be just 101.75; for $500,000, 101.5. A firm that could aggregate five different purchases for $100,000 would be able to save each investor one-half of one percent on the trade. As long as each buyer was willing to be patient so that a "group" could be put together, each buyer would benefit from the aggregation process.

Separate account managers may be able to perform tax loss harvesting without incurring large trading costs. Assume a separate account manager has two investors both living in California. Each owns a $100,000 AAA-rated California municipal bond of similar maturity but from different issuers. Assume rates have risen significantly since the original purchases were made. Both investors would like to be able to harvest losses, but trading costs would be high. The manager/adviser simply contacts a broker-dealer and asks them to "cross" two trades. Investor A buys the bond of investor B, and investor B buys investor A's bond. The term "cross" implies that both purchases and sales are done at the same price, with no markup or markdown. Because broker-dealers take no risk in the transaction, they are willing to perform the service for a relatively low fee, perhaps $50 to $75. This is only possible if the manager/adviser has a large enough client base to make cross trades possible.

A good way to access a separate account manager is through a fee-only registered investment adviser (RIA) providing such services. A small number of them provide investors with access to the wholesale markets. Although they won't add markups/downs to bond prices, service is not free: The investor pays for the value of the advice, typically an annual percentage of the total assets under management. However, the investor does avoid the fees of a money manager or mutual fund, helping offset the costs of the financial adviser's services. The adviser's value added services of fixed-income portfolio building and managing for taxes can be a bonus.

There is one more issue related to owning bond mutual funds (but not ETFs) of which investors should be both aware and concerned. Many bond funds, particularly closed-end funds that trade like stocks, use leverage in an attempt to increase returns. If they can borrow at a lower rate than the returns they earn, fund returns are enhanced. But leverage works both ways. In rising rate environments, its use can lead to outright losses. The use of leverage turns an investment into more of a speculation, a bet on interest rates. Funds employing leverage should be avoided.

The right answer on which approach is superior—individual securities or mutual funds (or ETFs)—depends on the unique situation of each investor, as well as how much they value convenience versus having to do it themselves.

If you are going to use mutual funds or ETFs, the following are our recommendations on selection criteria.