It's no secret that investors in stock mutual funds would be better off with an index fund -- essentially investing in the whole stock market rather than banking on a fund manger's ability to beat it (which, statistically, he isn't likely to do).
But is indexing the way to go for bond investors, too? The answer lies in one of the powerful advantages of indexing: low costs. Since index funds don't have to pay a team of analysts and managers, they can charge investors less -- this is reflected in lower expense ratios (i.e., the annual percentage of your money that will be taken out by the fund to cover costs).
In his article "High-cost Funds Give Little Return," (free registration required), Dallas Morning News columnist Scott Burns demonstrates how indexing is smart for bond fund investors, too. While exploring Morningstar's database on mutual funds, Burns found the following:
- Of the 642 taxable bond funds that have been around for at least a decade, only 68 have outperformed the Vanguard Total Bond Market Index Fund. In other words, almost 90% of bond funds under-preformed the index fund.
- Separating these funds into five groups according to expenses, the quintile with the highest fees had an average expense ratio of 1.66 and posted an average annual return of 4.92%. The least-expensive quintile of funds charged 0.46% a year and returned 6.51% annually on average.
- Low expenses don't guarantee outperformance. Only 32% of the cheapest funds bested the index. But that beats the pants off the most expensive funds, of which only 4.7% outperformed the index.
So indexing works for bond funds, too. The next question, then, is whether you should own bond funds at all. As many pundits have explained (including the Fool's Mathew Emmert in "Broken Bonds"), interest rates and bond prices have an inverse relationship: If rates rise, then bond prices fall, and vice-versa.
With interest rates at historic lows, it is more likely that rates will rise rather than fall over the long term. In fact, since rates began rising in mid-June, the net asset value of the Vanguard Total Market Index has declined 4.4%. And as the stock market has once again looked like a money-making proposition, the cash going into bonds has declined. According to Lipper, net inflows into bond funds dropped 25% in June compared to May.
You can learn more about the advantages and disadvantages of bond funds and individual bonds in "Bonds vs. Bond Funds." If you think a fund makes sense for you, then consider sticking with short- and intermediate-term bond funds since long-term funds will be more sensitive to interest rate changes, and the extra yield isn't worth the risk in most cases.
And, of course, stick with an index fund.