Bond Index Funds Trail, Exposing Flaws

BOSTON (TheStreet) -- Bond index funds and exchange traded funds have been trailing well behind actively managed funds this year.

Notable laggards include Vanguard Total Bond Market Index(VBMFX Quote), the largest bond index fund, which has been trailing 90% of its intermediate-term bond competitors, according to Morningstar. Among underperforming high-yield choices is iShares iBoxx $ High Yield Corporate Bond(HYG Quote), an ETF that has been 17 percentage points behind the average junk bond mutual fund.

Should you dump the indexers? Not necessarily. But investors should be aware of crucial flaws in the funds that were underlined during the market turmoil of the past year.

Consider Vanguard Total Bond, which tracks the Barclays Aggregate Bond index. Because of its low fees and solid long-term track record, some investors have put their entire bond allocation into the Vanguard fund. But that can be a mistake, as shareholders discovered this year.

The problem with the index is that it's not as diversified as the fund's name suggests. About 79% of the Barclays benchmark is in Treasuries and other bonds rated AAA. The index has few corporate bonds and excludes junk and foreign bonds altogether. "I would not put all my money into a fund that tracks the aggregate index," says Dave Nadig, research director of indexuniverse.com. "I would rather cover wide sectors by holding separate corporate and government funds."

In 2008, the emphasis on high-quality bonds helped the results of funds that track the Barclays aggregate, including Vanguard Total Bond Market and Schwab Total Bond(SWLBX Quote). As bond markets froze, investors dumped corporate issues and bid up prices of Treasuries. This year, corporate bonds outperformed, so Vanguard and Schwab lagged well behind many actively managed funds.