Bond Investors Are joining the Index Fund Parade

By ELIZABETH HARRIS (NYT) 1098 words

BOND index funds have been catching on, and for good reasons. Like stock index funds, they have cheaper fees, more transparent holdings and higher average annual returns, over time, than the vast majority of actively managed funds in their category.

Still, stock investments tend to hog the spotlight and crowd out fixed-income options in the world of mutual funds, and this has certainly been true when it comes to indexing. Nearly every corner of the equity world has been sliced into an index that is tracked by some fund or another, ranging from small-capitalization stocks to health care shares to the ever popular Standard & Poor’s 500-stock index. There are 231 stock index mutual funds, compared with only 23 bond index funds, according to Morningstar.

Bond indexes aren’t household names, either. ”Investors are much more familiar with stock index funds,” said Scott Berry, a mutual funds analyst at Morningstar. ”With the Lehman Brothers index, you’ve got thousands of issuers who investors may not have even heard of.”

Still, bond index mutual funds have not been ignored; they are offered by mutual fund companies including Fidelity Investments, Charles Schwab, T. Rowe Price and Vanguard. At the end of June, these funds’ assets were $58 billion, compared with nearly $833 billion in actively managed taxable bond funds, according to preliminary numbers from Morningstar. Fourteen out of 23 bond index funds have performed better than their category average over the three years through June, according to Morningstar. The group performed even better over five years, with 18 out of 20 funds with five-year records beating the category average, according to Morningstar.

”By and large, you’re not giving up performance,” said Dave Yeske, a certified financial planner and president of Yeske & Company in San Francisco.

While some fund managers may be able to earn some extra return, it usually means taking additional risk, he said. ”There’s no free ride,” Mr. Yeske said, ”so you might as well do anything to minimize expenses and that’s where index funds are so effective.”

Lower expenses give index funds a head start each year. Because mutual fund returns are calculated by starting with the total gain, then subtracting costs, lower expenses help lift a fund’s overall return. The expenses of the average bond index fund are only 0.43 percent annually, compared with 1.13 percent for actively managed bond funds. That advantage can have significant consequences for bond investors because the annual returns of bonds are typically lower than those for stocks, said Ken Volpert, a senior portfolio manager and principal at Vanguard who oversees the company’s bond index group. It’s a bonus that the additional return is available without adding to a portfolio’s volatility by, say, buying bonds with more credit risk. ”The benefits of indexing are durable,” Mr. Volpert said. ”They’re there for you every year.”

Investors in bond index funds also benefit from knowing that all the bonds in their funds come from the index the manager tracks. Most bond index funds track the Lehman Brothers U.S. Aggregate index, which at the end of the quarter had an average duration, a measure of sensitivity to interest rate changes, of about 4.2 years and an average credit quality of AA with about a third in United States government bonds.

The index also requires a minimum rating of investment grade. But a new guideline that took effect on July 1 has slightly changed which bonds are eligible. Previously, Lehman looked at assessments from Standard & Poor’s and Moody’s Investors Service; if analysts from either firm rated an issuer’s bonds as junk, they were removed from Lehman’s index. But now, adding a third perspective from Fitch Ratings has meant a more diverse list of issuers. Because two of the three agencies must agree on a noninvestment grade rating rather than just one of two, 80 issues were added to the Lehman index at the end of the quarter. They include Ford Motor, FirstEnergy and Amerada Hess, Mr. Volpert said.

Ideally, relying on three opinions will help add more stability to the index, potentially reducing the number of changes to the index, said Ford E. O’Neil, portfolio manager of the $5.7 billion Fidelity U.S. Bond Index fund.

But the indexing of bonds still poses special challenges. Thousands of individual bonds are represented in Lehman’s bond index, some of which may be illiquid and infrequently traded.

That makes it impossible for a bond index fund manager to own the entire index. So managers employ a sampling technique in which they buy bonds to create a portfolio whose characteristics resemble the overall index. (While stock index funds can also use this technique, they may not need to do so, because most stock indexes are made up of fewer issues.)

This means that some bond index funds vary in composition. While most hew closely to the Lehman index in terms of the bonds’ average quality and maturities, index funds may hold vastly different numbers of bonds. The Vanguard Total Bond Market Index fund, for example, has more than 2,000 individual bonds, while the Schwab Total Bond Market fund had 285 at the end of May.

Some index funds may have a slightly different complexion than the Lehman Brothers index. For example, managers of the Fidelity U.S. Bond Index fund may take calculated bets by slightly overweighting a type of bond, say mortgage-backed bonds, compared with the larger index.

Costs, too, can vary. While expenses in the average index fund fall below those of most actively managed bond funds, they may range from an annual 0.18 percent for the Vanguard Intermediate-Term Bond Index fund to 0.71 percent for the Gartmore Bond Index fund. The costs can drop even further among the six Barclays bond exchange-traded funds: four have expenses of just 0.15 percent a year, while the other two charge 0.20 percent.

One possible disadvantage of bond index funds is that they do not allow for much, if any, international diversification. Many investors could benefit from such foreign exposure, Mr. Yeske said.

”You really want to be diversified globally with your bonds,” he said. ”You don’t necessarily want to be held hostage to the interest rate or business cycle in your own country.”