The Benefits and Risks of Bond Index Funds

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A bond index fund is a fund that invests in a portfolio of bonds designed to match the performance of a particular index, such as the Barclays Aggregate U.S. Bond Index. Investors can buy index-related products using either traditional bond mutual funds or the growing number of exchange-traded funds (ETFs) which can be purchased through a broker. These products are a simple and cost-effective way to invest in bonds. With extensive diversification, low fees, and an approach that’s easily understood by the average investor, bond index funds may well be a leading option for those who are seeking to earn investment income.

Passive Management

Rather than being actively managed—i.e., with a portfolio manager who tries to choose bonds that will outperform the index over time—the index fund simply holds the securities that are in the index, or, in many cases, a representative sample of the index holdings. When the composition of the index changes, so will the holdings in the fund.

Lower Management Fees

The “expense ratio” is the percentage of assets that the fund company takes off the top each year to pay its expenses and earn a profit, and index funds help minimize this impact. The average domestic taxable bond fund has an expense ratio of a little over 1.0%, while the average international and high-yield bond fund each check in with an expense ratio of about 1.35%. Most bond index funds charge an annual fee of about 0.2% to 0.4%.

Since these funds require fewer resources to manage, they can pass the savings along to investors. In contrast to actively managed funds, the similarity of funds within a particular category allows investors to shop around for the fund with the lowest fee (thereby maximizing their longer-term returns).

These fees take a large chunk of investors' cash over time, especially in light of the fact that companies charge the fees regardless of how their funds perform. This is even more of a consideration in today’s low-yield environment. If a fund’s portfolio only yields 4%, a 1% management fee wipes out over a quarter of an investors’ income.

Consistent Performance

With an index fund, you know what you’ll be getting—a return that’s representative of the broader market. With active managers, performance results can experience wide swings. One year the manager can outperform the index by two percentage points, but the next year he may lag by five. And over time, active managers, as a group, tend to lag the index funds by a wide margin.

One reason for this is that the higher fees not only take a bite out of returns, but they also force the active managers to take on more risk just to match the performance of the index after fees. Still, even the best managers can substantially underperform the markets from time to time. Investors need to ask if higher fees are worth it for the uneven performance typical of actively managed funds.

Hidden Risks

For funds that mirror broad-based benchmarks such as the Barclays U.S. Aggregate Index, a substantial portion of the portfolio is typically invested in government or government-related securities. That equates to high-interest rate risk, which is fine when yields are falling (as prices rise). However, rising rates will have an extremely negative impact on a portfolio heavily tilted toward government bonds. Investors may, therefore, want to look for ways to augment their index funds with investments that have lower interest rate risk, such as high-yield and emerging market bonds.

Disclaimer: The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.