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Bond Index Funds Trail, Exposing Flaws

The shares of iShares Barclays Aggregate Bond have traded at a premium for the past year. The premium spiked to 2.21% in December 2008 and currently remains at 0.52%. So investors who bought last year could have paid $1.02 for a dollar's worth of assets. Today the same assets are worth less than $1.01. The declining premium eroded returns for investors.

Premiums have posed a special drag for some investors in high-yield ETFs, such as iShares iBoxx $ High Yield Corporate Bond. The premium rose to 10.96% in December 2008 and has since dropped to 1.56%. The premiums help explain why the ETF has underperformed the average high-yield mutual fund.

Premiums have also hurt municipal ETFs, such as SPDR Lehman Municipal Bond (TFI), which has returned 8.2% this year, lagging behind average long municipal mutual funds by 8 percentage points. The municipal ETF sold for a premium of 1.02% in 2008. Since then, the premium has dropped to 0.31%.

Some analysts argue that high-yield municipal index funds suffer from the way their holdings are weighted in the benchmark. In the typical bond index fund, issuers with more debt outstanding carry more weight. Say two companies have the same amount of sales, but one has four times as much debt. Bonds from the debt-heavy issuer would account for four times more of the index than issues from the low-debt company.

Critics say this is no way to run an index fund. "Bond investors know that it makes no sense to be shoveling more and more money into the bond offerings of a company that is borrowing more and more," says Rob Arnott, portfolio manager of PIMCO All Asset (PASAX).

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