The battle over bond funds: active or index?

What's a better conservative investment, a bond index fund or an actively managed one?

Generally, I believe strongly in bond index funds. The best ones charge little in fees, so they have an advantage over most mutual funds because your money isn't drained away.

Historically, low-cost index funds such as the Vanguard Total Bond Market Index or the Vanguard Total Stock Market Index have left most funds in the dust even though many others hire smart managers to try to do better than indexes.

Still, some investors have reservations about relying exclusively on a bond index fund now because we are in an unusual period.

By definition, index funds don't make day-to-day decisions. The index bond funds simply mimic the full bond market, or a slice of it. They don't try to steer clear of bonds that might weaken and default. They don't look for bonds that might be safer. They simply acquire an array of bonds and stick with them.

In the case of the Vanguard Total Bond Market Index, the riskiest bonds in the market — "high-yield" or "junk" bonds — are not included because they are not part of the Barclays Aggregate Bond Market Index, which the Vanguard fund is mimicking.

The bond fund was in the right place at the right time last year, advancing 5.1 percent, because the index was stuffed with U.S. Treasury bonds and what are essentially government-guaranteed bonds issued by entities such as Freddie Mac and Fannie Mae.

Just 26 percent of the portfolio was in corporate bonds, or the type of bonds investors feared.

As a result, the Vanguard fund topped 89 percent of other bond funds last year. Many active managers did poorly as they tried to buy corporate bonds they thought were cheap. For example, highly respected Loomis Sayles lost 22 percent. The average bond fund fell about 7.4 percent.

Yet Morningstar bond-fund analyst Miriam Sjoblom said that investors going into the future with their focus on 2008 could be sorely disappointed.

Treasurys soared in 2008 and government-guaranteed bonds were popular because investors were scared. But investors have poured so much money into the safe bonds, Sjoblom said, they are considered expensive.

With time, the government may have to pay higher interest rates on bonds. When that happens, the value of the old Treasurys will fall because investors will want to earn higher interest.

At that point — no one can predict when — bond funds holding a lot of Treasurys could lose value.

Sjoblom isn't predicting index funds will become losers. Rather, she suggests the high Treasury exposure could hold the funds back compared with funds with the leeway to pick and choose bonds that they think have better prospects.

She notes that many bond-fund managers are buying corporate bonds.

Among the funds shopping in that area is the FPA New Income Fund, whose managers, Robert Rodriguez and Thomas Atteberry, were named fixed-income managers of the year by Morningstar.

The FPA fund, which gained 4.3 percent last year, is attractive now because Rodriguez and Atteberry shop for bonds with potential but are conservative about their choices.