What’s the secret to tight bond index fund tracking?

Most managers of equity index funds typically seek to track a benchmark’s returns by buying all the stocks in it at market weights. That approach is not practical for many fixed income index fund managers due to the structure of the bond market, which features relatively higher cost and lower liquidity compared to equities.

The complexities of the bond market may leave investors with the impression that it’s not possible to effectively track a broad bond benchmark, but that’s a misconception, according to Josh Barrickman, a co-author of the research note and head of indexing for Vanguard Fixed Income Group.

“Bond index fund managers can target performance that closely matches the benchmark by aligning the fund’s key risk-factor exposures with the benchmark while also keeping transaction costs low,” Barrickman said. “It’s a balancing act between tracking error and costs. As the first company to offer a bond index fund, we’ve spent decades sharpening our techniques to offer some of the most competitive funds in the market.”

Bond index fund managers use several tools to balance the trade-offs between tracking error and costs. One is sampling, which involves selecting and weighting a subset of benchmark bonds to mimic the benchmark’s risk-factor exposures. Sampling alone won’t eliminate tracking error, however, so portfolio managers also use:

• Multifactor risk models, which spot correlations among risk factors and assess portfolio risk at the macro and micro levels.

• Optimization models, which are quantitative tools that seek asset combinations that can help meet an objective, such as minimizing tracking error versus a benchmark, while adhering to constraints, such as issuer concentration limits.

Barrickman and his co-authors compared the tracking error of portfolios that align duration, credit quality, and sector risk-factor exposures with the benchmark to those that randomly select the same number of bonds but don’t match benchmark risk exposures. They show that risk-aligned portfolios consistently reported lower tracking error.

“By building portfolios with bonds that best represent the risk-factor exposures of the benchmark, portfolio managers can buy fewer securities and bypass those that are expensive to trade,” Barrickman said. “Keeping transaction costs low helps us to deliver as much of the market return as possible to our investors.”

Vanguard’s global team of portfolio managers, traders, risk specialists, and credit analysts work every day to identify opportunities that strike a balance between transaction cost savings and closely tracking a benchmark.

For instance, when Ford Motor Company’s bonds were added to the Bloomberg U.S. Aggregate Bond Index in 2023, Vanguard’s bond index team initially delayed adding Ford’s full exposure, instead partially allocating to another auto issuer, General Motors. The two companies had similar risk characteristics, but Ford was trading at a premium as demand surged upon its addition to the index. By maintaining a higher allocation to GM until valuations normalized, Vanguard’s bond index team capitalized on a temporary mispricing while maintaining tight benchmark tracking.

“We’re always on the hunt for opportunities like this,” Barrickman said. “They help us fulfill one of our primary missions, which is to pursue benchmark returns while keeping costs low to give investors the best chance for investment success.”