Comparing bonds funds

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NEW YORK (Money Magazine) -- Question: Every time I research bond mutual funds, I encounter the word "duration." What is it and how should it influence my investing? - Carl T. Copley, Bellevue, Wash.

Answer: You probably already know that a bond fund's value rises and falls with the movement of interest rates in the economy. Duration reveals how much a fund (or a single bond) is boosted or whacked by changing rates.

That's useful for comparing funds' interest-rate risks. Let's say you're deciding between two Vanguard index funds - the Long-Term Bond (ticker symbol: VBLTX) and the Intermediate-Term Bond (VBIIX).

Lately, the long-term fund is yielding 5.42 percent while the intermediate-term fund is yielding 4.99 percent. Go for the bigger yield, right?

Not necessarily. The duration of the lower-yielding intermediate-term fund is 5.9 years, meaning that if interest rates were to rise one percentage point, the fund's shares would fall by about 6 percent. (Similarly, they would rise by 6 percent if rates fell a point.) But the long-term fund's duration is 11.1 years, so a percentage-point shift in rates would move shares 11 percent in either direction.

Is a half-point more in yield worth the extra risk if interest rates rise? You decide, but remember that you're usually buying bonds to reduce risk in your portfolio.

Duration - always less than or equal to a bond's maturity - generally rises along with a bond's term. While maturity tells you something about interest-rate risk, duration does the job more precisely.

Question: Your magazine acknowledges fund manager Bill Miller's success with the Legg Mason Value Trust. So why not include it in your MONEY 70 list of recommended funds? Even if the fees are high, wouldn't an investor be better off in it? - Corbett Dabbs, Ellicott City, Md.

Answer: Hmm. Answer Guy's heart says one thing, his head another. The heart says yes, include Value Trust (LMVTX) because, well, Bill Miller is Bill Miller, one of the greatest portfolio managers of our time. Also, A.G. is lucky enough to have had a broker put him in Value Trust in the early 1990s; he still has the shares.

But the head wins out. Yes, Miller beat the S&P 500 annually from 1991 through 2005. But he's even with the index over the past five years, and he's lagging badly this year, owing partly to a premature bet on the housing market's recovery. This is not to say that Miller now stinks; rather, the point is that you can't know when Value Trust will resume its market-beating performance.

On the other hand, research repeatedly shows that the best predictor of above-average mutual fund results is below-average expenses.

Morningstar, for example, found that 47 percent of the least expensive domestic stock funds beat their category average, compared with 19 percent of the most expensive ones. That's why A.G. concurs that Value Trust, with its 1.7 percent expense ratio for retail investors, shouldn't be in the MONEY 70, where the highest expense ratio for large-cap funds is 0.99 percent.

As a rule, you're better off following the expense guideline than trying to pick the managers who will prove to be the exceptions.

Looking for some answers? Send us your questions about investing. E-mail answer_guy@moneymail.com.