| 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:
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