Bond Index Funds-a Synopsis                          Page 4

Instead they use sophisticated computer programs to select a cross-section of issues from this Lehman Brothers index that is representative of the index as a whole in terms of duration, cash flow distribution, sector and quality weights, and other characteristics. For instance, at times when 30% of the Lehman Brothers Aggregate Bond Index is composed of mortgage-backed securities, the managers of Vanguard's Total Bond Market Index would invest about 30% of the fund's assets in mortgage-backed securities that have similar characteristics as a group to those in the Lehman Brothers broad index. As of 12/31/99 the Lehman Brothers Aggregate Bond Index was composed thus:

International U.S. dollar denominated bonds are issued by foreign governments and companies in U.S. dollars, usually in order to attract U.S. investors.

Hardly "Passive" Management

Kenneth Volpert, senior manager of Vanguard's bond index funds, likes to say, "People say that these funds can be run by a monkey. That's not true." He understates his case. The truth is that these managers tinker a lot with their portfolios, though not as much so as the so-called "active managers." Usually bond index funds hold only a little more than 80% of their assets in bonds enumerated in the Lehman Bothers index. The other 20% of the bonds have characteristics - like maturity, credit quality, and issuer type-similar to those in the index, but not the actual issues enumerated there.

And, as the Vanguard bond index funds prospectus puts it, "To the extent that the funds invest outside of the index, they may employ active management strategies. The index and non-index securities, in combination, will have characteristics and risks similar to the index." The prospectus goes on to authorize further managerial latitude for these managers. For instance, Vanguard fund managers nearly always make use of an option in the prospectus called "corporate substitution," whereby managers can overweight particular types of corporate bonds relative to their representation in the index.
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