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), 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), 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). 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.

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.

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).

Arnott says blindly following a debt-weighted index can be especially hazardous for investors in riskier assets such as high-yield and emerging market bonds. He says that in 2002, PIMCO active bond managers backed away from holding Argentine bonds, even though they accounted for a big percentage of the index. By avoiding bonds that soon collapsed, the PIMCO funds outperformed.

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

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