• Bond indices often hold many thousands of securities, creating a challenge for managers of funds seeking to track those indices.
  
  
• Through techniques such as sampling and risk-factor alignment, managers can mimic the characteristics of an index without holding every constituent.
  
  
• Effective index fund management can lead to minimal tracking error while keeping costs low.
   

To understand the challenges of managing bond index funds, consider this: The Bloomberg Global Aggregate Float Adjusted and Scaled Index contains nearly 31,000 fixed income securities, while the FTSE All-World Index comprises around 4,200 equity securities¹. The breadth of the fixed income market is just one of the challenges bond index fund managers face. At Vanguard, our portfolio managers take on these challenges in support of their goal to closely track a benchmark.

Navigating the bond market is demanding

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 with 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. 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. It’s a balancing act between tracking error and costs. As the first company to offer a bond index fund, at Vanguard we’ve spent decades sharpening our techniques to offer some of the most competitive funds in the market.

Tools of the bond index fund management trade

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

Risk-factor alignment helps balance the trade-offs between tracking error and cost

We 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. Keeping transaction costs low helps us to deliver as much of the market return as possible to our investors.

A real-world example

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, which is a subset of the Bloomberg Global Aggregate Float Adjusted and Scaled 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 normalised, Vanguard’s bond index team capitalised on a temporary mispricing while maintaining tight benchmark tracking.

Our bond index team is always on the hunt for opportunities like this. Such opportunities help the team fulfill one of its primary missions, which is to pursue benchmark returns while keeping costs low to give investors the best chance for investment success.

Please visit our index and ETF investing pages to learn more about our capabilities.
 

¹ Source: Bloomberg. As of 28 February 2025, the Bloomberg Global Aggregate Float Adjusted and Scaled Index contained 30,834 bonds and the FTSE All-World Index contained 4,243 stocks. 
 

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