Rather than buying one aggregate bond index fund that tracks the broad U.S. fixed income market, are investors trying to build bond portfolios that track the broad bond market by holding targeted index funds that track specific sectors of the bond market, such as corporates, U.S. Treasuries, or mortgage-backed securities?
Among those who are holding index funds that target a specific segment of the bond market, we found that the effect of this decision is that those investors are much more likely to be using these index funds to take active positions against the market. To successfully maintain a passive portfolio using targeted index funds, you must weight these funds according to the segments they are tracking in their market-capitalization proportion to the total market.
This is not easy to do in fixed income―particularly U.S. dollar-denominated fixed income―because the asset class is heterogeneous and there isn’t an agreed-upon definition of the total market. For example, should the total market include taxable as well as tax-exempt fixed income; should it include investment-grade as well as high-yield fixed income? Should Treasury Inflation-Protected Securities be included?