Best and Worst Taxable Bond Index Funds

DESPERATE MEASURES ARE often born in desperate times, and today's investing environment is no exception. From mutual funds that let you double-short stocks to ETFs enticing you to double-long oil, there are options aplenty out there that promise to make up for underperforming equities. But why reinvent the wheel when good ol' bonds, a traditional safe haven, can add stability to a portfolio rocked by stock volatility.

One of the simplest and cheapest ways to buy bonds is through a mutual fund or ETF that tracks an index of fixed-income securities. This passive approach can help you avoid the pitfalls of actively managed funds, whose managers might be tempted to chase higher yields by buying riskier debts. Not all index funds, however, do a great job tracking their indexes. It's a feat one Morningstar analyst has called "art as well as science," because bond indexes often have thousands of holdings that are difficult to replicate precisely.

So we asked Lipper for help finding the best and cheapest bond index mutual funds and ETFs available to retail investors based on three-year returns, as well as the worst and most expensive ones. We limited the search to taxable bond funds, ruling out municipal bonds, which are best held outside of tax-sheltered accounts. We also cut out funds requiring minimum investments above $5,000. The big winners: ETFs from iShares and mutual funds from Vanguard, all of which track fixed-income benchmarks from Lehman Brothers (LEH). (See chart below.)

Keep in mind that bond index funds tend to hold more government securities, which are particularly sensitive to changes in short-term interest rates. Bond values fall as interest rates rise, and the Federal Reserve has signaled an end to rate cuts — and possible rate hikes down the road to combat inflation. But don't let that deter you. "People shouldn't get into doing a lot of tactical asset allocation," says Morningstar's personal finance director Christine Benz. "Studies show that for someone who's quite a ways from retirement, adding just 10% in fixed income really brings down volatility without cutting into returns too much."

Also See:
Best Money-Market Mutual Funds
Get Better Yields Without ARPS-Like Risk
Best and Worst S&P 500 Index Funds by Cost