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Bond index funds’ low costs gain favor with investors

A key attraction is the low fees that

A key attraction is the low fees that bond index funds charge. Photo Credit: iStock

Forget trying to beat the market.

Investors have been doing it for years with their stock funds, content to get simply the market average with index funds — and to pay their correspondingly low fees. Now, more investors are making the move with the bond part of their portfolio as well.

They’re pulling their savings out of actively managed bond funds and moving instead into mutual funds and exchange-traded funds that track bond indexes. The trend began in 2013, when the U.S. bond market had its first losing year in more than a decade.

It’s grown steadily enough that $27 of every $100 in bond funds is now in an index fund, according to Morningstar. That’s a record percentage. Bond index funds controlled only about half that as recently as 2008.

A key attraction is the low fees that index funds charge. Bond index funds overall keep $10 of every $10,000 invested annually to cover their expenses, according to the Investment Company Institute. Actively managed bond funds keep $60.

“It’s hard to justify the cost of active management in fixed income with yields as low as they are,” says Stephen Janachowski, CEO at Brouwer & Janachowski, a financial advisory firm that manages $1.3 billion in assets.

The yield on a 10-year Treasury note is just 1.74 percent, down from 5 percent a decade ago and 15 percent in the early 1980s. It’s important to keep as much of that slim amount as possible.

Bond index funds have also performed relatively well recently, which has helped draw more dollars. Just 6 percent of funds that invest in investment-grade, intermediate-term bonds were able to match or beat a corresponding index last year, according to S&P Dow Jones Indices.

Anyone considering a move into bond index funds, though, should first pay close attention to what’s in the index.

Many are heavy in Treasurys and other government debt. These bonds will likely hold up best when the stock market is tanking, but they also have the lowest yields in an already low-yield universe.

The starting point for deciding whether to buy a fund should perhaps be whether it charges high or low expenses, rather than whether it employs an active manager.

More than any other factor, a fund’s expense ratio “is the most proven predictor of future fund returns,” a recent study by Morningstar found. The cheapest funds more often end up being among the successful ones, regardless of what they invest in.

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