Bond Index Funds-a Synopsis                         Page 10

Morningstar Study Concludes That It's Unclear Whether Bond Index Funds Are Best

In an October, 1998 study of five years' worth of bond mutual fund performance, researchers at Morningstar concluded that with taxable bond funds "managers running intermediate-term funds have managed to outrun their index on the upside, and long-term funds have done better than their benchmark on the downside." This is explained in part because most long-term bond funds are less sensitive to changes in interest rates than the index. This keeps fund returns down when bonds are rallying, as they did for much of the '90s, but keeps things stable when bond prices fall.

On the other hand, intermediate funds in general carry longer-term debt than their benchmarks, which pays off during bond rallies. The Morningstar editors went on to recommend Vanguard's Bond Index Total Market [VBMFX] and the Fidelity U.S. Bond Index [FBIDX] among bond index funds, as well as Loomis Sayles Bond [LSBRX] and Warburg Pincus Fixed Income [CUFIX] among the actively-managed funds. The study concluded that "the low costs of index funds are a real benefit in this area of the market, but we wouldn't count out active managers...Bottom line...Taxable Bonds: Could go either way."

Bond Index Fund Managers Can't Monitor Credit Quality or Call Risk as Closely

Many feel that bond index fund managers are ill-equipped to manage credit quality, that is, to select the highest quality bonds from any sector, and moreover to anticipate which are likely to be upgraded by the credit agencies. Also, active managers can potentially better control "call risk," the possibility that certain bonds with "call features" may be redeemed before maturity in a period of falling interest rates and rising bond prices. The active manager is probably better positioned to invest only in bonds that cannot be called and thereby to avoid having to reinvest assets at lower interest rates when higher-yielding bonds are redeemed.

Some Investors Don't Like Having Treasuries in Bond Index Funds

Some mutual fund customers complain that they don't need or want to pay a management fee to hold treasury bonds in a portfolio, since they can buy treasury bonds commission-free from the government. And some say they would prefer to hold only corporate bonds or GNMAs in a high-quality index fund, but that such funds don't exist at present. (Morningstar.com)
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