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Bond Funds With an Edge

Since the fundamental ETF has been running for only a year, it is too soon to make any conclusive judgments about the approach. But it is clear that the new ETF has a higher credit quality than its cap-weighted competitors.

The average credit quality of Arnott's fund is double-B, one step below investment grade. In contrast, iShares iBoxx $ High Yield Corporate Bond (HYG), a cap-weighted competitor, has a lower rating of single-B.

During the past year, both high-yield funds have delivered nearly identical returns of 8.7%, according to Morningstar. But the fundamental fund has proved more resilient in difficult times. During the turmoil of the past month, the iShares fund lost 1.8%, while the PowerShares fund stayed in the black, returning 0.4%.

Along with Arnott's fund, another way to avoid cap-weighting is to buy actively managed funds. These have the freedom to focus on quality issuers and avoid the most heavily indebted borrowers.

A top active choice is Dodge & Cox Income (DODIX), a high-quality intermediate fund that aims to outdo the Barclays benchmark.

During the past 10 years, the fund has returned 6.3% annually, compared to 5.9% for the index. In addition to Treasuries, the fund has a big stake in corporate bonds. Issues in the portfolio include bonds from Bank of America (BAC) and Citigroup (C).

Another solid active fund is Janus Flexible Bond (JAFIX), which has returned 6.7% annually during the past 10 years. The fund can shift its allocations, emphasizing sectors that appear undervalued.

Janus limited losses during the downturn of 2008 by putting 60% of assets in Treasuries.

These days Treasuries seem rich, and the fund has 68% of assets in corporate bonds. Holdings include bonds from Tyson Foods (TNS) and American International Group (AIG).

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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