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 like traditional bond mutual funds or they can choose from the growing number of exchange-traded funds (ETFs), which can be traded 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.

Key Takeaways

  • A bond index fund is a fund that invests in a portfolio of bonds designed to match the performance of a particular index.
  • Index funds are passively managed, which means they have lower management fees. 
  • Index funds perform more consistently than actively managed funds.

Passive Management

Index funds differ from other ETFs and mutual funds in that they are passively managed. With actively managed funds, a portfolio manager 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, that change is mirrored in the fund's holdings.

Lower Management Fees

The “expense ratio” is the percentage of assets that the fund company skims off the top each year to cover its expenses, pay its employees, and earn a profit. Since index funds simply track an index, there are fewer costs associated with operating the fund, and the fund can pass those savings along to investors in the form of low expense ratios.

There's also little difference between index funds, making it easy for investors to shop around for their best option. While actively managed funds are highly dependant upon management's choices, all index funds that track the same index should hold relatively similar investments and experience relatively similar performance. Therefore, investors can focus more heavily on the expense ratios among competing funds.

For examples of how much fees can differ, let's look at a few iShares ETFs from the financial institution BlackRock, Inc. The iShares Interest Rate Hedged High-Yield Bond ETF (ticker: HYGH) is an actively managed fund with a net expense ratio of 0.53%. The iShares Interest Rate Hedged Emerging Markets Bond ETF (ticker: EMBH) is another actively managed ETF that focuses on international bonds, and it comes with a net expense ratio of 0.48%. On the other hand, look at an index fund like the iShares Core U.S. Aggregate Bond ETF (ticker: AGG), which has a net expense ratio of 0.05%.

The fractional difference between these fees may not seem significant, but if you're investing over long periods, those differences add up. Investors should also consider the impact of fees in today's low-yield environment. If a fund’s portfolio only yields 4% on a given year, for example, a 1% management fee wipes out about 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 2%, but next year, they may lag by 5%. Not only is the performance of actively managed funds more inconsistent than index funds, but over longer timeframes, studies by an organization like Morningstar suggest the majority of active managers lag behind index funds.

Hidden Risks

For funds like AGG, which 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 comes with high levels of interest rate risk. When yields are falling, and bond prices rise, this is fine. However, rising rates will have an extremely negative impact on a portfolio that's 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.

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.