To Index Bonds or Not?

Editor's note: This article is part of our "How and Why to Invest in Bonds" series. Click here to read other articles.

Much of the advantage that index-tracking equity funds can have over actively managed funds, where portfolio managers are choosing individual securities, comes from lower costs. For bond funds, where returns are generally lower over time than stock funds, fees can have a substantial impact on an investors’ outcome.

However, many corners of the bond market are much less actively traded than the stock market and information on issuers can be harder to come by. That's one big reason that the U.S. municipal-bond fund universe is largely the domain of actively managed funds. But in the most actively traded other corners of the market, index funds have increasingly become the foundation of many portfolios thanks to their low costs.

And, as Morningstar columnist John Rekenthaler wrote, the advantage among core bond funds over the long term could still go to the index funds thanks to the head start they get from low expenses, even though many active funds have outperformed recently thanks to their bigger holdings of riskier debt while shunning more-conservative bonds, such as U.S. Treasuries:

"Which is better: Index funds or the active managers? For a complete market cycle, probably the indexer. I don’t see why the answer should vary according to the investment sector. Over time, the decisions of a group of portfolio managers have a roughly neutral effect, which means that the indexer leads by the size of its cost advantage. The analysis becomes more complicated if the index fund holds a somewhat different portfolio than the category average, as in this instance, but the general point remains."

Ben Johnson, Morningstar Research Services' director for passive research, says, when it comes to making a fund-by-fund decision to go with an index or active manager, the first stop should simply be the Morningstar Analyst Ratings. But more broadly, Ben says Morningstar prefers index-tracking funds that are underpinned by indexes that capture the full breadth of a broad category rather than ones that are more narrowly focused. For example, an investor looking for an intermediate bond investment may be better served with an index fund tracking the Bloomberg Barclays U.S. Aggregate Bond Index than one just focused on the high-yield bond market.

Part 5: How Much of a Portfolio Should Be Invested in Bonds?

The following authors contributed to this series:

Tom Lauricella, Editorial Director, Professional Audiences Christine Benz, Director of Personal Finance Sarah Bush, Director, Fixed-Income Strategies Jeff Westergaard, Director, Fixed-Income Data

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