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Bond Index Funds Trail, Exposing Flaws

Investors who rely too heavily on the Vanguard index fund could trail in future years. At the moment, many bond analysts believe that Treasuries are overvalued. If Treasuries collapse, funds that track the Barclays Aggregate could be in for a long period of subpar performance.

Faced with headwinds, Vanguard Total Bond has returned 6.3% this year, trailing the average intermediate-term fund by 6 percentage points. Some bond ETFs have done even worse. Among the trailing ETFs are iShares Barclays Aggregate Bond (AGG), which only returned 3.5%, and SPDR Barclays Capital Aggregate Bond (LAG) (LAG), with a 3.3% return. Part of the problem can be attributed to how the ETFs are assembled. To track the benchmark, the open-end Vanguard fund holds more than 10,000 separate securities. But the iShares ETF only holds a sample of some 250 bonds. This year the ETFs did not hold some top-performing bonds. "Because of the sampling, the ETF performance can vary substantially from the index," says Nadig of indexuniverse.com.

Besides the flawed sampling, ETFs can also suffer when their shares sell for premiums or discounts to the value of the net assets in their portfolios. As demand for an ETF grows, the price of the shares can move to a premium. In the case of a fund that tracks a major stock benchmark, such as the S&P 500, the premium usually vanishes quickly. Taking advantage of the mispricing, institutions make arbitrage trades, producing fast profits and driving prices back into line with the value of net assets. But bonds do not trade so smoothly, and premiums can persist for days or weeks.

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