The Problem With Bond Indexes

Though I believe in combining passive and active investing strategies, it is important to realize that not all indexes are the same. This is particularly the case when it comes to bond indexes. Bond indexes are harder for a manager to replicate than stock indexes because of multiple bond issues and liquidity constraints.

Most companies issue a single class of common stock. Even when there are two classes, stock indexes only hold one of the two classes. Berkshire Hathaway provides an example. The S&P 500 index holds class B shares (BRK.B), not the significantly more costly class A shares (BRK.A).

Conversely, many companies have multiple bond issues. A bond maturing in three years will have different characteristics than a bond maturing in seven years, even if both are issued by the same company. Thus, replicating a bond index is not as simple as merely adding General Electric (GE) bonds. The same issue has to be held in order to replicate the index.