When Simpler Isn’t Better: Why A Bond Index Fund May Not Be The Right Choice

Simple is good, right? In fact, if you read the popular financial magazines and websites geared toward consumers, you’ll walk away with the impression that simpler and cheaper is always better. There’s only one problem. It’s just not true.

Sometimes a little complexity is better, and you do get what you pay for.

Here’s a case in point. The simplest and cheapest way to invest in bonds is to use a bond index fund that makes no attempt to “manage” the portfolio. It just buys bonds in proportions reflecting the holdings of the broad bond market. Many people seem to think that investing in just this one simple bond index gives them the coverage they need.

We’ve never agreed, and you can see some of the reasons why in our previous blog posts, such as Time To Rethink Your Bond Strategy? and Simple Isn’t Always Better (At Least For Bonds).

And now that interest rates are rising, a more nuanced and diversified approach to bond investing – like the one we favor – is paying off with better investment results.

“Active money managers are handily beating the cheaper index-tracking competition, largely because they are doing a better job protecting their portfolios from rising interest rates,” writes the Wall Street Journal.

The popular bond index funds are stuffed full of long duration government bonds “that will suffer greater losses when rates rise,” says the Journal.

A one-size-fits-all index approach may have worked in the past, especially in a favorable investment climate offering decades of falling interest rates. That’s like shooting fish in a barrel in the bond world. It’s hard to go wrong.

But now, times are tougher. The investment climate is less favorable and requires much more skill to navigate.

And why invest in bonds at all? We believe you still need bonds or bond-like investments in your portfolio to provide stability and income, and hedge against potential stock market losses.

So if you have too much money in simple bond index funds, it may be time to make a change. “Mom-and-pop investors who have gobbled up passive funds in recent years … may not realize that their safe-haven bond funds are vulnerable to rising rates,” says Marina Gross of Natixis.

The Takeaway: Forget the one-stop-shopping approach to bonds. While bond index funds have their place, they should be only a part of your bond portfolio, not the whole enchilada. Diversify your bond holdings to add different types of bonds that will satisfy your need for income, while standing up to rising rates.

About Mari Adam

Mari Adam, Certified Financial Planner™ and President of Adam Financial Associates Inc, has been helping individuals and families chart their financial futures for over twenty-five years. Have a question about your financial situation? Ask Mari!

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