In my last post, I argued that virtually all long-term investors should have a significant allocation to bonds in their portfolio. That raises an obvious practical question: if you’re a Couch Potato investor, which bond index fund should you use?

Let’s begin by looking at the most widely followed fixed-income benchmark in Canada: the DEX Universe Bond Index. It consists of about 70% government issues (45% federal, 24% provincial and 1% municipal) and 30% corporate bonds. About half of the bonds in the index have maturities of five years or less, about a quarter mature within five to ten years, and another quarter extend past ten years. In short, this index has it all (with the notable exception of real-return bonds). If you’re looking for a single fund that covers the Canadian investment-grade bond market, look for one that tracks the DEX Universe.

Your bond fund choices

While there is a wide variety of fixed-income ETFs in Canada, only one follows this key benchmark, and that’s the aptly named iShares DEX Universe Bond Index Fund (XBB). Launched in 2000 (which makes it ancient by ETF standards), XBB has more than $1.6 billion in assets and an MER of just 0.33%.

The Claymore Advantaged Canadian Bond ETF (CAB) and BMO Aggregate Bond Index ETF (ZAG) track similar indexes and have low fees, but both are less than a year old and don’t have a track record or significant trading volume. I see no point in choosing them over the iShares incumbent.

As for index mutual funds that track the DEX Universe Bond Index, there are four to choose from:

TD Canadian Bond Index – e TDB909
TD Canadian Bond Index – I TDB966
CIBC Canadian Bond Index CIB503
Scotia Canadian Bond Index BNS386

How have they performed?

I waded through the Management Reports of Fund Performance for all of these funds to see how they have fared since 2001. The DEX Universe index is enormous and can’t be fully replicated: fund managers use representative sampling to try to match the index returns as best they can. I expected this to lead to some significant differences in performance, and it seems to have been a factor in few random instances. But over time the variation in returns is largely explained by the MERs:

iShares TD (e) TD (I) CIBC Scotia
2001 5.7% 7.6% 7.0% 7.1% 6.8%
2002 9.9% 8.3% 7.7% 7.9% 7.3%
2003 6.2% 6.0% 5.5% 5.7% 5.5%
2004 8.0% 6.5% 6.1% 6.1% 6.0%
2005 6.1% 6.0% 5.4% 5.5% 5.4%
2006 3.8% 3.6% 3.1% 3.1% 3.0%
2007 3.3% 3.2% 2.9% 2.6% 2.7%
2008 6.1% 5.7% 5.4% 4.0% 5.8%
2009 5.0% 4.6% 4.3% 5.1% 3.7%
Annualized 5.99% 5.71% 5.26% 5.22% 5.13%
MER 0.33% 0.48% 0.79% 1.06% 0.89%

It seems clear, then, that if you’re looking for a fund that comes closest to delivering the returns of the overall Canadian bond market, iShares’ XBB should be your first choice. By virtue of its low MER, it has consistently outperformed its more expensive peers.

If you’re looking for an index mutual fund rather than an ETF, the e-Series version of TD’s Canadian Bond Index Fund should top your list. The e-Series funds, however, are only available through a TD Mutual Funds account, or through TD Waterhouse. If you use another discount brokerage, consider the Investor Series version of this fund.

As overpriced as the CIBC and Scotia funds are, I can’t resist pointing out that both outperformed the average Canadian bond fund over the last 10 years, according to Morningstar. That’s not surprising, given that active management is useless in the efficient bond market, and that the average MER for Canadian bond funds is an absurdly high 1.70%.

As John Bogle says, when it comes to investing, you get what you don’t pay for.