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“Index Funds” Doesn’t Mean “Stocks”

I write a lot about how index funds are great tools for constructing a portfolio. Interestingly, one of the most common objections I hear against index funds is, “I don’t want to invest in the stock market.”

I’m not sure where the idea that index funds only own stocks came from, but it’s complete nonsense. There are numerous bond index funds, and they come in a wide variety of flavors–investment-grade corporate bonds, short-term Treasury bonds, mortgage-backed bonds, and so on.

An all-index-fund portfolio could just as easily be 100% bonds as 100% stocks. And the benefits of index funds (low-costs and diversification within the asset class in question) are just as important with bonds as they are for stocks.

Diversification Is Important for Bonds

In much the same way that it’s beneficial to diversify your stock holdings across numerous companies, it’s beneficial to diversify your bond holdings across numerous borrowers. With corporate bonds, it’s best to own bonds from a variety of companies in a variety of industries. And with municipal bonds, it’s best to own bonds from a variety of states/cities from around the country.

Noteworthy exception #1: There’s no need to diversify among different Treasury bonds. It’s perfectly OK to pick the most appropriate maturity for your purposes and stick with that.

Noteworthy exception #2: If you’re a muni bond investor who lives in a state that exempts in-state muni bonds from state income taxes, it likely makes sense to sacrifice some degree of diversification by overweighting in-state bonds in your asset allocation.

Costs Matter with Bond Funds Too

As important as it is to keep costs low when investing in stocks, it’s even more important when investing in bonds. The expected return of bonds is lower than that of stocks, so every tenth of a percent that goes to pay the fund manager takes a proportionally larger bite out of your final returns.

Unsurprisingly, if you browse the history of Standard & Poors Indices vs. Active Scorecards, you can see that actively managed bond funds have an even lower chance of outperforming their benchmark than actively managed stock funds do. (And that’s saying something!)

Diversifying Your Index Fund Portfolio

When financial advisors or writers suggest owning index funds, it’s unlikely that they’re recommending an index fund portfolio consisting exclusively of stocks. While stock index funds do provide a great deal of diversification across companies, it’s still important to include other asset classes.

Fortunately, the principles of keeping costs low and diversifying apply just as well to bonds as they do to stocks.

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Comments

  1. Perhaps one reason bond funds are not thought of as index funds results from the excessive influence of the very loud, very obnoxious Suze Orman, who seems unaware that a truly indexed bond fund like Vanguard’s Total Bond or Fidelity’s Spartan funds has as low an expense ratio as a comparable stock fund. From the horse’s mouth:

    “Earlier I mentioned that I am not a big fan of bond funds. Here’s why: The beauty of owning bonds directly is that if you choose a high-quality bond you are pretty assured that when the bond matures you will be repaid your entire initial investment, or ‘principal.’ So not only do you get the periodic interest payments from the bond, but there’s an extremely high probability you will get your principal back. In fact, if you invest in a U.S. Treasury bond, you are guaranteed to get your principal back at maturity. And when you buy a bond directly, you lock in the interest rate for the entire length of the bond. If you buy a 10-year bond with a 5 percent yield, you will get 5 percent for the next 10 years.

    “But a bond fund is different. That’s because there’s a manager at the helm who is actively buying and selling bonds rather than buying and holding them until maturity. So you lose the certainty of getting your principal back. And by the way, you have to pay that manager; the typical expense ratio on a bond fund is about 1 percent. You’re lucky to get a yield of 4 percent on a high-quality Treasury bond fund and you’re going to give back one quarter of that performance in a fee? That just doesn’t make sense to me.”
    http://au.pfinance.yahoo.com/b/moneymatters/23/mutual-funds-for-the-rest-of-us

    As someone on Bogleheads commented, “I think she’s wrong on a lot of things, and this is one of them.”

  2. Good Bogleheads debate on this topic:
    http://www.bogleheads.org/forum/viewtopic.php?t=9493

  3. Hi Larry.

    You could be right about the source of this misconception. (Not being a TV-watcher myself, I’m somewhat sheltered from the effects of mainstream personal finance “gurus.”)

    While I certainly don’t agree with her anti-bond-fund message, I agree that it’s not a good idea to buy a bond fund that charges a 1% expense ratio!

  4. Excellent post and I agree. Clearly an investor can have a fully diversified “all index” portfolio via mutual funds and ETFs. I’m not sure this is the right answer in all cases as I still use some active funds for specific purposes in many client portfolios, but like you I am a huge indexing fan. I am more likely to use an active bond manager than an active equity manager, but I use both types of bond funds extensively.

  5. You’ve raised a lot of great points here. I do think it’s important for investors to be aware of the risk to capital in bond funds, but it can be cost-prohibitive for the average investor with a smaller portfolio to invest in individual bonds.

    The idea that not every index fund contains stocks is an important distinction too. Thanks!

  6. A challenge for Ms. Orman: find one bond fund with a 5 year duration that has lost money over a 5 year period.

  7. I’m not Ms. Orman, but:

    Vanguard’s High-Yield Corporate Fund has a 4.7 year duration (at the moment, according to their website at least) and lost money for the 5 years ending 12/31/2008. I guess that’s why they call ‘em “junk.”

  8. @DIY Investor Your comment is correct I doubt that you would find any bond fund with a 5 year duration that has lost money over the past five years. However, the bigger issue is do you expect the next five years to be like the last five for bond fund investors?

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