(Bloomberg News) Bill Gross's Pimco Total Return Fund, the world's biggest mutual fund, is trailing a low-cost Vanguard index fund this year as some of the top bond investors were blindsided by the rally in Treasuries.

Gross' fund returned 1.5 percent this year through Oct. 4, compared with 8.9 percent for the $10.4 billion Vanguard Intermediate Term Bond Fund, which outperformed 99 percent of intermediate bond funds tracked by Chicago-based Morningstar Inc. The Vanguard fund, which tracks an index rather than trying to beat it, topped managers including Loomis Sayles & Co.'s Dan Fuss and TCW Group Inc.'s Tad Rivelle.

"At the beginning of the year I don't think many managers would have said Treasuries are the place to be or that the yield on the 10-year would go to 2 percent," Douglas Swanson, manager of the $21 billion JPMorgan Core Bond Fund, said in a telephone interview from Columbus, Ohio. His fund gained 6.5 percent this year.

The Vanguard fund, which beat 95 percent of funds over the past five years, won because it held bonds with longer maturities than rivals and three times as many Treasuries. While that allocation may hurt returns when interest rates start to rise, the fund's performance highlights the growing challenge to fixed-income managers from the passive strategies that have already grabbed a fifth of U.S. stock fund assets.

Bond funds have been shielded from indexing competition because unlike stock funds, they showed steady gains over the past decade, Chris Philips, a senior analyst at Valley Forge, Pennsylvania-based Vanguard, said in a telephone interview. Intermediate bond funds gained an average of 5 percent a year in the 10 years ended Oct. 4, Morningstar data show.

Index funds account for about 9 percent of bond fund assets, Morningstar data show, compared with 19 percent for stock funds. Funds run by stock pickers including Legg Mason Inc.'s Bill Miller and Kenneth Heebner of Capital Growth Management LP have experienced redemptions of $290 billion since the end of 2007, after they failed to protect investors from two bears markets in the past decade.

Bond markets are harder to track because of the number of securities in many bond indexes, said Gregory Davis, a principal in the bond indexing group at Vanguard. The Barclays Capital U.S. Aggregate Bond Index has about 8,000 bonds, Davis said. The Vanguard fund that mimics it has about 5,000 holdings.

The bond market is also less efficient than the stock market, said Morningstar analyst Eric Jacobson, because of the number of bonds outstanding and the complexity of the instruments. In theory, that should give active managers an advantage over index funds, he said.

That hasn't happened over the past five years, when just 25 percent of bond funds beat their benchmarks. That compares with 52 percent of equity-fund managers who outperformed, according to Lipper, a Denver-based research firm. A majority of actively managed bond funds failed to match their benchmarks in 10 of the last 11 years, according to Lipper. Active funds with 10 years of performance lagged behind the benchmarks by an average of 0.45 percent per year, Lipper data show.

"They quietly disappoint," said Jeff Tjornehoj, senior research analyst at Lipper, in an e-mail.

The $9.7 billion Natixis Loomis Sayles Investment Grade Bond Fund, co-managed by Fuss, returned 2.6 percent this year through Oct. 4, Bloomberg data show. The $15.8 billion Metropolitan West Total Return Bond Fund, co-managed by Rivelle, gained 4.1 percent. Fuss' fund had no money in Treasuries as of July 31. Rivelle had 9 percent in Treasuries as of June 30, according to Morningstar. Both funds trailed their benchmarks in 2011, Bloomberg data show. They beat more than 90 percent of rivals over 5 years and 10 years, Morningstar data show.

Coming into 2011, most bond managers assumed the U.S. economy would grow at a faster pace and that interest rates would rise, said Colin Lundgren, head of fixed income at Minneapolis-based Columbia Management Investment Advisers LLC, where he oversees $170 billion in bonds. To prepare for that scenario, they cut Treasuries and added corporate bonds, which are less sensitive to rates, he said.

"We have been in a massively unusual environment which made Treasuries very hot," Morningstar's Jacobson said in a telephone interview from Overland Park, Kansas. "Most managers didn't want to hold a lot of Treasuries because they yielded so little."

Treasuries outperformed corporate bonds and mortgage bonds in 2011, data from Bank of America Merrill Lynch indexes show, and bonds with 5-10 year maturities topped bonds with shorter due dates. Over the past five years, longer maturities also did better.

"We have been in the sweet spot," Vanguard's Davis said in a telephone interview.

The Vanguard fund tracks the Barclays Capital U.S. 5-10 Year Government/Credit Float Adjusted Index. As of Aug. 31, the fund had 52 percent of its money in Treasuries, 3 percent in government agency securities and most of the balance in corporate bonds, Davis said. The average intermediate bond fund had 15 percent of its assets in Treasuries as of June 30, Morningstar data show.

The Vanguard fund has an average duration of 6.4 years compared with 4.8 years for the typical intermediate bond fund, according to Morningstar. Duration is a measure of how much the price of a bond will change when interest rates rise or fall. Morningstar defines intermediate bonds as those with maturities between 4 and 10 years.

"Declining interest rates have overwhelmed everything else," Margie Patel, who manages more than $1 billion in stocks and bonds for Wells Capital Management Inc., said in a telephone interview from Boston. Bonds with longer maturities are more sensitive to changes in rates, Patel said.

Gross, co-chief investment officer at Pacific Investment Management Co., had been reducing the vulnerability of his Total Return Fund to interest-rate swings and increasing its reliance on credit quality since July 2010 by shifting from Treasuries to corporate and non-U.S. sovereign debt.

The strategy backfired in August as the U.S. economy slowed and Europe's debt crisis worsened. The $242 billion Pimco Total Return Fund trailed 80 percent of rivals so far in 2011, according to Bloomberg data.

The fund's Treasury holdings fell to zero as of February and in March Gross used derivatives to bet against the securities. Treasuries climbed to 16 percent of the portfolio in August, according to the website of the Newport Beach, California, firm.

In August, Gross told the Financial Times that it was a "mistake to bet so heavily against the price of U.S. government debt."

The Total Return Fund has a different benchmark than the Vanguard index fund, though it has the freedom to invest in the same bonds. Total Return normally stays within two years of the duration of the Barclays Capital US Aggregate Index, which was 5.2 years as of June 30, according to the fund's prospectus. The aggregate index is the main benchmark for most intermediate bond funds, according to Morningstar. Total Return beat that benchmark over 5 and 10 years, Bloomberg data show.

With most active managers underperforming and bond yields at or near record lows, the case for using index funds is just as compelling in fixed income as it is in stocks, said Vanguard's Philips. Bond index funds will match the market's performance over time and gain an edge through lower costs, he said.

The Vanguard Intermediate Bond Fund index charges a fee of 22 cents for every $100 invested compared with a weighted average of 59 cents for actively managed rivals, according to Lipper.

"In a world where bonds are only yielding 2 percent, that cost advantage is important," Philips said.

Index funds' market share has risen to 9 percent of bond mutual fund assets as of Aug. 31, from 3 percent in 2001, Morningstar data show.

The top active managers are still ahead over longer periods. Over five years, Pimco Total Return and Vanguard Intermediate Term Bond fund both gained about 7.7 percent a year, Bloomberg data show.

Over 10 years Gross' fund beat the index fund by roughly 10 basis points annually, Morningstar data show; over 15 years it won by about 25 basis points per year. A basis point is equal to .01 percentage point.

Mark Porterfield, a Pimco spokesman, did not respond to messages seeking comment.

Jeffrey Gundlach, founder of Los Angeles-based DoubleLine Capital LP, is one of the few managers of an intermediate bond fund who has topped the Vanguard index fund this year. His $720 million DoubleLine Core Fixed Income Fund returned 9.8 percent in 2011, Bloomberg data show. The fund had 17 percent of its assets in Treasuries as of Aug. 31, Morningstar data show.

Gundlach managed the TCW Total Return Fund from 1993 to 2009. It was the top-performing intermediate bond fund for the 15 years ended Nov. 30, 2009, with an annual return of 8.3 percent, according to Morningstar.

While acknowledging that Treasuries have been winners this year, Colin Lundgren of Columbia Management said the trend may not hold.

"For Treasuries to continue to outperform, we will need to see more bad news," said Lundgren, who expects corporate bonds to outpace Treasuries over the next 6 to 12 months.

Investors in the Vanguard Intermediate Bond Index Fund need to temper their expectations, said David Falkof, a Morningstar analyst who follows the fund.

"If rates rise, this fund will not fare as well as its peers," he said in a telephone interview.