How do I Choose the Best Bond Index Funds?

A. Leverkuhn
A. Leverkuhn
Businessman with a briefcase
Businessman with a briefcase

For choosing bond index funds that will give an investor the best chance of gains, some pretty solid tips related to doing the homework on funds can be a real life-saver. Although bond index funds are by nature less risky than some other fund types, it makes sense for a potential customer to dial down risks even further using careful research and knowledge of the bond market. Some of the biggest issues are around costs, fund strategies, and the way that fund managers set up these financial offers to chase money.

One of the hottest topics around bond index funds is their capitalization. More investors are looking at the way that index funds are structured, where a basket of stocks, bonds, or other securities are made to mirror an index or otherwise track the general performance of a sector. Some experts consider bond index funds that are “capitally weighted” to be problematic or not well built. Capitally weighted funds will have more of a focus on the biggest borrowers, which, in the eyes of some experienced traders, can make them less safe.

Along with proper weighting, some traders also recommend staying away from highly leveraged bond index funds, or other funds where the inherent stability of the index fund has been compromised by strange or exotic strategies. The renowned Burton Malkiel, father of the “Random Walk Down Wall Street,” which contributed to the market efficiency hypothesis, has been held up as a standard for recognizing the supremacy of index funds that work the way they are supposed to, by spreading risks around and adding a stable, steady growth potential to a portfolio. The best bond index funds are made with attention to market efficiency principles, limiting their likelihood of roller-coaster spikes and falls.

Another issue in any bond fund is the risk of default. Recent news has shown that municipalities and other big borrowers can default, or, more precisely, that ‘anyone’ can default, which has resulted in many investors re-configuring their estimation of bond markets in general. That doesn’t mean that bond index funds are not a desirable part of a portfolio for many experts. It does mean, though, that examining the fund thoroughly is even more important than it may have been in the past.

In choosing the best bond index funds, the investor should look at any costs, such as expense ratios, and fees, and balance those against likely yields. The investor should understand what the fund managers are trying to do, whether the fund is ‘actively’ or ‘passively’ managed, and how the management pursues re-balancing and other periodic tasks, with an eye toward the principles mentioned above. The investor should also look at the “guts” of a fund through its prospectus or other clarifying documentation to see how much of any given bond is included in the independently created “index.” It might help to compare the index fund to actual bond indices to see whether the fund is appropriately put together.

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