Bonds Index Funds Just As Compelling



Growing fears of an overvalued stock market have brought bonds back into the limelight. But investors' dilemma still remains which bond fund to invest in. Bond index funds, with their relatively low fees (around 0.2% compared to over 1% charged by active managers), have given investors more bang for the buck in their short 10-year, especially when fees and expenses are taken into account. The table below shows annualized returns taking into account fees and expenses.

Source: Morningstar Inc.; insufficient data for longer-term comparisons.

(Scroll down for a complete listing with performance statistics)

"Indexing has a place in portfolio decision making for both institutional as well as retail investors," says Kimon Daifotis, Portfolio Manager of the Schwab Total Bond Market Index Fund. "What part of a portfolio should be indexed all depends on risk tolerance. The most important thing is to have a portfolio including several asset classes, one being fixed income. Assigning part of the fixed income portfolio to index funds makes sense as they provide the market return, are cost-effective and tax-efficient.

"As a group, bond funds have failed to provide investors with adequate returns relative to those achieved by the bond market itself," writes John Bogle, Senior Chairman of the Vanguard Group in his book Common Sense on Mutual Funds. "Once the equity market environment turns more sober, future bond fund returns may well prove to be more competitive with stock fund returns. But, unless the bond fund industry changes its ways and gives shareholders a fair shake, bond funds will be on a treadmill to oblivion."

In fact, it's their high expense ratio that makes them underperform the average. Take for example an actively managed bond fund that delivers a market average gross annual return of 5% and charges 1% in annual fees. The fund yields only a 4% net return as the fees diminishes the bond fund investor's return by 20%. Due to the high fees, the fund manager must beat the market average by 25% just to provide investors with the market return. This in itself is a tough task, but the tougher proposition is for the investor to pick in advance the manager able to achieves such results. Besides the annual fees, sales loads (one-time fees to get into the fund) or hidden annual 12b-1 fees charged by most bond funds further reduces returns.

The most popular bond index funds (those considered in the above comparison) are those designed to match the performance of the Lehman Brothers Aggregate Bond Index. This index measures the total universe of investment-grade fixed-income securities in the U.S. - including 6600 government, corporate, mortgage-backed, asset-backed, and international dollar-denominated bonds, all with maturities of over one year (average maturity of 8.75 years).

Relatively few bond index funds exist as their low fees give little monetary incentive to fund managers. As long as mutual funds can get away with charging high fees and delivering below average returns on their active funds, they are going to be in no hurry to offer bond index funds. It is up to investors to desert high-cost bond funds and seek out well-managed low-cost funds, or bond index funds. The future of the bond fund industry lies in their hands.

A partial list of bond index funds:

Source: Morningstar Inc.

All returns are fee-adjusted and annualized. The credit rating is the S&P rating of a bond where AAA is the highest quality.