YO: BOND INDEX FUNDS WIELD BETTER YIELDS: LOWER COSTS GIVE THEM AVERAGE 0.7% EDGE, BUT FEW INVESTORS NOTICE

Though the attractions of stock index mutual fund investing are becoming familiar even to novices, bond index funds have remained stuck in relative obscurity.

Mutual fund researcher Morningstar Inc. counts just 19 taxable bond index funds with $14.9 billion in assets, vs. 103 domestic stock index funds with $205 billion in assets.

But with long-term Treasury rates hovering around 5.2%, and little expectation that they will spike up anytime soon, the lower cost structure of bond index funds may draw broader investor interest.

“If people thought about it, there should be a bigger move to bond index funds than there has been in the equity world,” says analyst Maciek Kowara, at Morningstar in Chicago.

That’s because as bond yields decline, fund expenses eat up a higher percentage of the fund’s yield. With the average actively managed taxable bond fund charging 1.1% against fund assets, investors are paying out 20% of their projected return in management fees and other expenses, he notes.

In contrast, the average bond index fund charges less than half that amount, or 0.45%. Index leader Vanguard Group of Malvern, Pa., charges just 0.2% for its Total Bond Market Portfolio index fund, which seeks to match the performance of the Lehman Brothers Aggregate Bond Index, a broad compilation of more than 6,000 issues of U.S. Treasuries, government agency securities, mortgage-backed and corporate bonds.

Over the last decade, those lower fees helped bond index funds return an average 8.9% annually, vs. 8.2% for actively managed taxable bond funds, according to Morningstar. The two biggest index bond funds — Vanguard’s $10 billion Total Bond Market and Fidelity Investments’ $1.2 billion U.S. Bond Index Portfolio — rank among the top 13% of intermediate bond funds, earning an average 7.2% annually over the five years ended in November.

Indexing lends itself especially to shorter-term corporate or U.S. government funds, where active managers have fewer opportunities to produce superior performance. In funds with holdings that have longer maturities, managers can sometimes outshine index funds by betting on the direction of interest rates, taking advantage of beaten-down industry sectors or assuming more risk and investing in lower-rated, higher yielding bonds.

It’s here that top managers like William Gross of Pimco Advisors Holdings LP in Newport Beach, Calif., stand out. Mr. Gross’s $24.2 billion Total Return Fund earned an average 10.3% annually over the 10 years ended in November, beating the Lehman Brothers Aggregate Bond Index by 1% annually. (Retail class A and C shares introduced in 1997 carry expense ratios of 0.91% and 1.67%, compared to 0.43% for the fund’s original institutional shares).

But while the low costs of bond index funds are attractive, some financial planners avoid them for other reasons. “It’s always good to have lesser fees,” says Gene Dongieux, president of Mercer Global Advisors Inc., a Santa Barbara, Calif.-based planner that manages $1.7 billion in assets, “but bond index funds have a tendency of being too long in duration,” a measure of volatility.

Mr. Dongieux points out that the popular Lehman aggregate bond index has a seven-year average maturity, vs. the two- to five-year range that his firm prefers. As an alternative, Mercer uses Dimensional Fund Advisors Inc.’s Two Year Global Fixed-Income Portfolio, a quantitative bond fund that carries a 0.34% expense ratio.

“Investors have been getting better educated over the years in the matters of investing, but most of this education has (concerned) stock funds,” says Morningstar’s Mr. Kowara. “People generally don’t understand bonds very well, so there will probably be a lag before indexing catches on in the bond world.”

The message appears to be getting across: Net sales of Boston-based Fidelity’s nine-year-old U.S. Bond Index Portfolio soared 527% to $455 million through November, vs. $72.6 million in net sales for all of 1997, according to Financial Research Corp. in Boston.

And Vanguard, which manages nearly 80% of all index bond fund assets, says net sales for its five fixed-income index funds expanded 37% last year. Sales of the company’s five-year-old Short-Term, Intermediate-Term and Long-Term index bond funds rose 145%, 89% and 200%, respectively.