There are numerous reasons why fixed-income assets should be mainly indexed.

Perhaps one of the primary issues is relative returns. Performance measurement studies such as PIPER (P&I Performance Evaluation Report calculated by Morningstar) are strong evidence that there is little value added in active management of fixed income.

Based on the latest PIPER study (through March 31), the difference between first-quartile and median in their fixed-income universe is quite small (about 51 to 62 basis points).

More importantly, the median or average fixed-income manager loses to a benchmark index (such as the Barclays Government Corporate) in both the last five- and 10-year rolling periods.

Noteworthy is that these calculations are before fees are deducted from the equation. After fees (estimated at about 25 basis points), even first-quartile or above-average fixed-income management would lose to the benchmark index.

PIPER Study Of U.S. Fixed-Income Taxable Separate Accounts

(periods ending 03/31/09)

There are also other advantages and reasons for indexing fixed-income assets, such as:

• Asset Allocation Models – Asset allocation usually accounts for over 90% of an investor's total return and becomes the most critical asset decision. Such models use 100% index data to calculate their recommended allocations, suggesting that active bond management is not even part of the asset allocation decision. In harmony with these models, bond index funds are the best representation of the intended risk/reward of this asset class.
• Fees – The asset management fees to manage bond index funds are usually quite lower than active management fees. Such annual savings can accumulate to significant cost reductions over time.
• Tracking Error – By definition, an index fund should have the least tracking deviation, thereby giving investors comfort that they will consistently receive the risk/reward of their benchmark index.
• Transparency – Most bond index benchmarks publish daily returns, unlike active managers who publish monthly or even quarterly returns, usually with a few days of delinquency. Such transparency should provide investors with more information on the risk/reward behavior of their assets so there are no surprises at quarterly asset management review meetings.
• Hire and Fire – It is usually a tedious and costly exercise for clients to hire and fire asset managers. Such cost and time dilution can be reduced, if not erased, through indexing to the benchmark index. This should also facilitate and support asset allocation, which can make more timely and easier shifts to their asset allocation.

An index fund is the least risky and least costly portfolio to achieve the investor’s objective. The real decision is what index best represents the investor’s objective.

Ron Ryan is a guest blogger at IndexUniverse.com. He’s co-founder and chief executive of Ryan ALM Inc., an index provider and research firm based in New York City.