Are Bond Index Funds Flawed?

Last Updated Mar 28, 2010 11:35 AM EDT

Does it make sense to index the bond market? Research Affiliates' Rob Arnott doesn't think so.

A recent article in Barron's spotlighted Arnott's criticism of traditional bond market indexes, which is, essentially, that because bond indexes are capitalization weighted, the biggest borrowers are given the largest weight -- the more they owe, the larger their share of the bond index.

Perhaps unsurprisingly, Arnott's firm has developed new bond indexes that are free of such flaws.

So if you own a bond index fund, should you be concerned? It's hard to see why.

It is true that bond indexes are heavily weighted toward the most indebted borrowers. But the amount of debt outstanding doesn't mean much, in and of itself. Consider, for example, if both Warren Buffett and I were bond issuers, and Buffett had $10 million in debt outstanding, and I had $5 million in debt. If the amount of our debt was of foremost concern to investors, I would seem to be the more appealing investment. But in this case, (and you'll have to trust me here) Buffett would be able to handle his larger debt load far easier than I could handle my smaller one.

Secondly, it is inaccurate to imply that the risks of this supposed flaw are borne only by bond index fund investors. The overwhelming majority of bond fund assets are held in actively managed funds, so it would follow that the overwhelming majority of the bonds issued by borrowers that may (or may not) be "too big" are held by actively managed funds.

Finally, it's useful to put some numbers behind these assertions. Consider the General Motors example given in the Barron's article. In early 2005, as the article notes, GM was the largest corporate bond issuer in the Barclay's U.S. Aggregate Bond index. In May of that year, GM debt lost its investment-grade status. Because the index only includes investment-grade debt, GM was booted.

Sounds scary, right? But consider the composition of the index. At the beginning of 2005, corporate-issued debt made up just 21 percent of the Barclay's U.S. Aggregate Bond index. Treasury and government-related debt made up 40 percent, and securitized loans the remaining 39 percent. GM's weight in the index at that time? 0.61 percent. To be sure, GM was the largest corporate component of the index, but phrasing it that way might imply that they were a larger portion of the overall index than they really were.

Further, what investors might not realize is that bond index funds have a good deal of flexibility in following the index. The bond market is massive, and it's impossible for a bond index fund to own a proportional share of every bond in the index. So index fund managers use a technique known as "sampling," which, if done right, allows the fund to track the return of the broad index without owning every single bond therein.

To see the impact of this sampling technique in action, consider the amount of GM debt that two of the largest total bond market index funds owned prior to GM's downgrade in 2005. To do so, we simply need to check the funds' old annual reports (helpfully available in the SEC's Edgar database), which provide each fund's total holdings for their fiscal year-end. As of December 31, 2004 GM's debt represented 0.12 percent of Vanguard's Total Bond Market fund's assets. At the end of February 2005, 0.36 percent of Fidelity U.S. Bond Index fund's assets were in GM debt. Both index funds, in other words, were underweighted in GM debt prior to the firm's downgrade.

Finally, it's worth considering what really matters to investors: performance. According to Morningstar, over the past five years (a period which includes the GM downgrade) the average intermediate-term bond fund has earned an annual return of 4.5 percent. Fidelity's U.S. Bond Index fund's return in the same period was 5 percent, while Vanguard's Total Bond Market earned 5.4 percent. It would seem that if those two funds were hindered by a flaw in the overall index during that period, they suffered less for it than their actively managed counterparts.

Flaws or no, it seems clear that improving upon a low-cost, broadly diversified bond index fund is a high hurdle. Investors convinced they've found a way to do so might be well-advised to be wary of innovators bearing back-tested strategies.

  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.