Bond Index Funds-a Synopsis                          Page 7

It should be noted that managers of high-cost funds are almost certainly at times tempted to overcome this performance disadvantage by taking on additional risk. Conversely managers of low-cost funds are often able to provide competitive returns with a lower level of risk than other funds.
Also, because indexing is a buy-and-hold strategy, bond index funds often enjoy a lower turnover rate, which is expressed as the percentage of issues in the portfolio that are either bought or sold over the course of a year.

The lower costs and tax advantages of indexing, however, provide a smaller advantage for bond index funds than for stock index funds. In part that's because the current income paid by a bond fund is usually more significant than potential capital gains, and that current income is taxable. Also, because bonds mature, they must be replaced by the fund, while a stock index fund may hold some stocks indefinitely.

Particularly Tough to Beat the Market in Bonds

As mentioned above, bond index funds consistently beat actively managed funds by 0.7% or 0.8% annually. In large part this is because bond fund managers have great difficulty beating the indexes, even more so than do stock fund managers. Unlike stock funds, bond funds vary little in their gross returns. Once an investor has chosen a level of credit quality and average maturity, most bond funds will have a similar gross yield-the yield before expenses. It is really expenses more than anything that differentiates bond funds, and it is index funds that are the leaders in keeping expenses down.

By virtually all accounts, the world of high grade bonds is far more homogenous than the stock market in both risks and returns. Kenneth Volpert, a senior bond fund manager for the Vanguard Group, said that it's unlikely that a small-cap growth stock fund manager can consistently pick stocks that outperform the S&P 500 and the Wilshire 5000. But he said that chances are far worse that a high-grade bond fund manager will consistently outperform a bond index such as the Lehman Brothers Aggregate Bond Index. (Chicago Tribune 7/19/98, C3).

Alice Lowenstein, bond editor at Morningstar Research says, "The investment-grade bond area, with high-quality, highly liquid securities, is an ideal place for index investing. There's very little a manager can do. There's no surer way to outperform among high-quality bond funds than to have smaller expenses." Indexing also lends itself especially well to shorter-term corporate and U.S. government bonds, where active managers have still fewer opportunities to outperform the indexes.
<<Previous                       Next >>

Printer Friendly Page