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Bond Index Funds vs. Bond Mutual Funds

Bond index funds track the composition of a given bond index. Because of passive management their management fees are lower, making them attractive investment.

Bond index funds are not actively managed but constructed to match the composition of a given bond index, such as the Lehman 10-year Bond Index, which is a benchmark index made up of the Lehman Brothers Government index, Corporate Bond Index, Mortgage-Backed Securities Index and Asset-Backed Securities Index, including securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million. When the index changes, the portfolio changes automatically.

Barely Passive Management

Even bond index funds are not totally passive in their management. Usually they hold only a little more than 80% of their assets in bonds enumerated in the Lehman Brothers index. The other 20% of the bonds have characteristics - like maturity, credit quality and issuer type similar to those in the index, but may employ active management strategies. For example, managers can overweight particular types of corporate bonds relative to their representation in the index.

Sometimes it's astonishing how far beyond the indexes prospectuses allow their fund managers to go. Some 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.

Advantages of Index Over Actively Managed Bond Funds

Consistent and Superior Performance

They consistently beat actively managed funds by 0.7% or 0.8% annually and they mostly outperform 85% of bond mutual funds in any period. Besides, standard deviation risk of bond index funds is usually lower than risk of the average mutual fund.

Lower Operating Expenses

The main reason for superior returns are significantly lower expenses that bond index funds incur. Especially when bond yields are low, operating expenses represent a high percentage of any bond fund's return.

And lower expenses are the result of little need for research departments; computers perform a much larger proportion of the funds' analytical work. And actively-managed bond funds almost always trade more. Consequently they incur a variety of extra expenses such as greater brokerage fees and greater capital gains tax payouts. In addition, actively-managed funds tend to keep some assets in low-yielding money market funds to cover investor redemptions.

It should be noted that managers of high-cost funds are 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.

Once an investor has chosen a level of credit quality and average maturity, most bond funds will have a similar yield before expenses. It is really expenses more than anything that differentiates them and it is index funds that are the leaders in keeping expenses down.

Diversification

A rarely-noted advantage is that they are frequently more diversified, since they hold a wide variety of government and corporate bonds and mortgage-backed securities, which is usually not the case with actively-managed funds, where managers often favor the more liquid issues.

Disadvantages of Index vs. Actively Managed Bond Funds

They are more sensitive to changes in interest rates than most long-term bond mutual funds. This keeps mutual fund returns down when bonds are rallying, but keeps things stable when bond prices fall.

Managers are too much focused on selecting 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.

One of the cons arguments is about nonsense to pay a management fee to hold treasury bonds in a portfolio, since investors can buy treasury bonds commission-free from the government.

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