A company that purchases bonds to match an index is called a bond index fund. It then turns the bonds into securities and offers them to buyers—the Barclays Aggregate U.S. Bond Benchmark, for example, is one index that the index fund aims to replicate. You can choose from a growing selection of exchange-traded funds (ETFs) traded through a broker or index-related products like bond mutual funds. Bond index funds are well-diversified, cost-effective, and employ a common-sense methodology. These items make investing in bonds easy and affordable. Bond index funds can be the best choice for investors who want to generate income from their investments.
Key Takeaways
- A company that invests in a portfolio of bonds created to replicate the performance of a specific index is known as a bond index fund.
- Since index funds are handled passively, they have reduced management costs.
- Index funds outperform actively managed funds more frequently.
Passive Management
The fact that index funds are passively managed sets them apart from other ETFs and mutual funds. In actively managed funds, the manager looks for bonds that will ultimately do better than the index. The bonds mentioned on the index are all that the index fund holds. Some funds employ a representative sample of the bonds in the index. The bond index fund's holdings adjust to reflect changes to the bonds included in the index.Lower Management Fees
The amount of assets that the fund business deducts annually from the top to pay bills, pay personnel, and turn a profit is known as the "expense ratio." Index funds have lower operating costs because they merely follow an index. Low expense ratios are, therefore, a way for the fund to share those savings with investors. Additionally, there aren't many differences between index funds, making it simple to compare your options. All index funds that follow the same index should hold comparable investments and experience comparable performance, but actively managed funds heavily depend on management's decisions. With that in mind, you can narrow down your search to competitor funds' expense ratios. Examine a few iShares ETFs from BlackRock, Inc. to see how different fees might be. The actively managed iShares Interest Rate Hedged High-Yield Bond ETF (HYGH) has a net expense ratio of 0.52 percent. Although it might not seem like much, the little differences in fees can build up over time if you invest for a long time. Another actively managed ETF that follows foreign bonds is the iShares Interest Rate Hedged Emerging Markets Bond ETF (EMBH). The net expense ratio for this investment is 0.47 percent. 2 On the other side, take a look at an index fund with a net expense ratio of 0.04 percent, such as the iShares Core U.S. Aggregate Bond ETF (AGG). In the current low-yield climate, you also need to take fees into account. A 1 percent management charge, for instance, would eat up approximately a quarter of your income if a fund's portfolio only yielded 4% in a given year.Consistent Performance
You know what you're getting with an index fund. Your return will be comparable to that of the general market. Active managers can, however, cause significant performance variations. The manager may perform 2 percent better than the index one year, then perform 5 percent worse the following year. In addition to having less consistent performance than index funds, actively managed funds generally perform worse over longer time horizons.Hidden Risks
AGG is one of many funds that follow large benchmarks like the Barclays U.S. Aggregate Index. Government or government-related securities make up a sizable portfolio component in this kind of fund. High-interest rate risk is associated with it. This is acceptable when yields are down, and bond prices are rising. Government bonds will lose a lot of value if interest rates rise, and it will be challenging to sell them if you have an entire portfolio. You might want to consider adding bonds with reduced interest rate risk, such as high-yield and emerging market bonds, to your bond index funds.