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Active vs. Passive in the World of Bonds


Advocates of bond index mutual funds aren't doing much bragging right now.

The indexing strategy, which looked good during 1995's bond market rally, fizzled a bit during the first six months of this year. Rising interest rates led to lower prices for individual bonds, as well as bond mutual fund net asset values, of virtually every stripe. Index funds have not made money this year.

But that's not surprising, considering that index funds tend to lead during market rallies and lag during retreats.

Bond funds, designed for investors who are primarily interested in income from their investments, are more convenient than putting together your own bond portfolio, and for small investors they are really the only practical way to spread the risk of changing yield or default.

Managers of regular bond funds can potentially maximize returns by switching into less-risky bonds if they foresee trouble. Index funds do not have this option. They are obligated to own the same bonds as are represented in a target index or benchmark, in the same proportion. The goal of an index fund is to mimic the performance of the relevant market yardstick, for better or worse.

Most of the time, it's for the better. The long-term historical returns of bonds may not match the stock market, but they certainly beat simple cash investments.

Meanwhile, the active bond managers have to predict interest rate movements to beat the averages. (When interest rates rise, bond values drop; when rates drop, bond values rise.)

So when bond prices are stable or rising, index funds enjoy an edge because they are fully invested. Index fund shareholders do not have to worry that their managers might guess incorrectly on the direction of interest rates by playing it too conservatively when the market rallies. In this sense, index funds are more predictable.

"Just like individual investors tend to buy and sell at the wrong times, professional fund managers often jump in after a market move has taken place, buying near the top and selling near the bottom," says Kenneth Volpert, senior portfolio manager in charge of bond index funds for the Vanguard Group.

But index portfolios often don't look so appealing. During this year's first half, their returns were mediocre.

Vanguard's Total Bond Market Index portfolio, the largest fund of its type, with $3 billion in assets, slid 2.3% from January through Thursday, even after including interest income. That compares with an 18% return in 1995, when the fund ranked in the top quartile of all bond portfolios.

Vanguard's Intermediate-Term Bond Index and Long-Term Bond Index fared a bit worse for the year through Wednesday, sliding 3.7% and 7.9%, respectively. SEI Bond Index of Wayne, Pa., fell 2.5% during 1996's first half, Portico Bond Immdex in Milwaukee dropped 2.7% and Fidelity U.S. Bond Index of Boston was off 2.3%.

All of the above funds scored superior gains in 1995.

In addition to maintaining a fully invested, predictable investment posture--a good idea most of the time--index funds enjoy a cost edge. There are fewer research and staff expenses.

At Vanguard, which has captured most of the $4.5-billion market for bond index funds, annual expenses run a scant 0.2%, equivalent to $2 for each $1,000 investment. On bond funds generally, average expenses approximate 1%.

However, the vast majority of bond funds are actively managed, and it's not hard to find critics of the index approach among the managers.

Tad Rivelle, co-manager of two highly rated bond funds for the Hotchkis & Wiley group in Los Angeles, observes that each index is a somewhat arbitrary concoction of individual bonds that might not be well-suited for a particular investor. And he points out that a skilled fund manager can outperform an index by loading up on bargain bonds when prices are cheap.

Daniel Fuss, who runs the Boston-based Loomis Sayles Bond Fund, said investors who do not want an actively managed bond fund could put together a "laddered" portfolio of individual bonds rather than using index funds. With a laddering strategy, an investor would buy bonds maturing in different years, thereby receiving a range of yields and interest rate sensitivities.

But laddering can cost more, although zero-coupon bonds minimize the amount spent on each "step."

The debate over indexing remains open, primarily because there are so few bond index funds--they are not a high-profit fund. Excluding the Vanguard portfolios discussed above, for which the minimum investment is $3,000, most other funds of this genre are available only to wealthy investors or through intermediaries.

Russ Wiles, a financial writer for the Arizona Republic, specializes in mutual funds.

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