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Can Indexing work for Bond Investors?

Do we need actively managed ETFs

Can Indexing work for Bond Investors?

By Ronald L. DeLegge - March 5, 2007


As equity markets throughout the world hit the skids, more investors could turn to the bond market for solace.


With major international and U.S. stock indexes stuck in reverse, one popular measure of bond performance, the iShares Lehman Aggregate Bond ETF (NYSE: AGG) is ahead by 1.75 percent on the year.*


Both academic and statistical evidence support the argument that indexing works for equity investors, but what about bond investors?


No better way to know than to look at the recent performance.


And the Embarrassing Results are...

Over the past five years, Standard & Poor's data reveals that corresponding Lehman Brothers bond indexes have handedly outperformed the majority of Wall Street's fixed income managers. From long-term government bonds to global bonds, fund managers as a group have been miserable. (See chart below)


But wait, there's more.


What about expenses?


Have bond fund managers been earning their keep? The statistics seem to suggest no.


Because the expenses of actively managed bond funds are typically higher than indexed bond ETFs it adds a higher level of cost. Based upon S&P's latest data, the only thing active bond investors have been getting for their higher fees are substandard returns.


Fund Category No. of Underperforming Bond Funds over 5-Years
Government Long 89.80%
Government Intermediate 70.19%
Government Short 75.51%
High Yield 84.44%
Mortgage Backed Securities 85.71%
Global Fixed Income 63.33%

Data through December 31, 2006


According to ETFguide's own quarterly survey, the expense ratio average for all bond ETFs was a lowly 0.18 percent. Since low expense ratios are good for investors, that means there are plenty of deals to be had in ETF land for even the stingiest of income investors.


Since bond returns tend to be historically lower than equities, keeping a lid on expenses is especially important.


Along with lower expense ratios the menu selection of bond ETFs continues to improve too.


Barclays Global Investors (BGI) recently introduced eight bond ETFs on the New York Stock Exchange (NYSE). The new funds track Lehman bond indexes and the move boosted the total number of fixed income ETFs to 14.


Besides proving that indexing can work for income investors, the dominant performance of bond indexes tells another important truth: It pays to have the indexes on your side.


*through March 2, 2007

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