Bond Index Funds-a Synopsis                          Page 5

A favorite gambit is to snap up corporate issues late in the fourth quarter after they've been dumped by Wall Street firm, as happens almost every year. (Business Week online 3/13/98). Vanguard bond index funds limit corporate substitution to bonds with less than four years remaining to maturity, and each bond index fund limits corporate substitutions to about 15% of assets.

It's astonishing how far beyond the indexes these prospectuses allow their fund managers to go. Vanguard's short, intermediate, and long term bond index funds are at times composed of a basket of securities, 35% of which are outside the Lehman Brothers subindexes, including smaller public issues or medium term notes not in the index because they're too small. These funds managers may also buy money market instruments and some derivatives in order to manage cash flow, to reduce transaction costs, or to take advantage of arbitrage opportunities when they arise. One example of such an arbitrage opportunity occurs when Treasury bond futures prices are significantly lower than the cash index. In such a situation Volpert and other bond index fund managers will often buy bond futures and hold them until near expiration because at expiration cash and futures prices are, by definition, identical. (Business Week online 3/13/98)

The Vanguard prospectus stipulates that each bond index fund's obligation to buy bonds under futures contracts may not exceed 20% of the fund's total assets. This alone would hardly be comforting to anyone suspecting fund managers of wild speculation. The fact is though, that managers at Vanguard and most other houses use these various investment options very conservatively to make up their miniscule (0.20%-0.50%) operating expenses and perhaps a couple of basis points more. It should be noted that some of the smaller bond index funds have more vaguely-worded prospectuses, although they contain otherwise similar stipulations. Investors should investigate these funds more thoroughly before investing in them and understand that under these prospectuses their managers are allowed even greater latitude from the pure indexing ideal.
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