Bond index fund tracking errors amid volatility
19 June 2020 | Markets and Economy
Kunal Mehta and Fatima Ait Moulay, fixed income investment product specialists, examine how the tracking errors of fixed income index funds can react to heightened market volatility.
The coronavirus crisis rocked global financial markets in March, and fixed income was no exception.
Faced with economic uncertainty, sharp drawdowns in equities and a heightened need for cash, many investors sought liquidity from their holdings in the bond market. Even the parts of the global fixed income market considered the most liquid, such as US Treasury bonds, felt the strain.
As volatility increased, the greater demand for liquidity in the bond market had implications for the pricing of bonds and bond funds. Consequently, it also impacted the tracking error of fixed income index funds.
But tracking errors have historically risen temporarily during similarly volatile periods in the past, only to eventually fall to within normal ranges, as we saw when trading and liquidity normalised following the downturn in March.
What’s more, volatility is not the only driver of tracking errors.
Replicating an index
The primary aim of a fixed income index fund manager is to replicate, as closely and cost-effectively as possible, the return and risk of a bond index. As a result, they seek to minimise tracking error, which is a measure of the consistency of a fund’s excess return versus its benchmark over time.
Tracking error varies over the market cycle and can be influenced by external factors, such as the volatility we experienced as a consequence of the Covid-19 pandemic. But it can also be minimised through careful intervention by the fund manager.
The impact of volatility
Unlike most equity markets, bonds typically trade over the counter, and a single market-clearing price is not always available. As a result, variations in the pricing of similar securities can arise. For fixed income index funds, this occurs primarily because the fund typically has different pricing sources to the benchmark it is tracking. This allows the index fund manager to maintain an independent view as to the fair value of the constituent securities.
Vanguard uses several third-party pricing providers and these follow a pricing hierarchy. In contrast, Bloomberg Barclays Indices—the benchmark provider for all Vanguard UCITS fixed income funds—uses Bloomberg’s Evaluated Pricing service (BVAL). This can lead to price differences, and these can increase during times of heightened market volatility.
In one way, the impact of the volatility caused by the coronavirus crisis on tracking errors is nothing new. The first chart below shows the Chicago Board Options Exchange Volatility Index (VIX), a widely used measure of expected market volatility, over the past decade. The second chart shows the trailing 12-month tracking error of Vanguard’s Global Bond Index Fund over time as an example of how tracking errors can increase during volatile periods.
CBOE Volatility Index during crises
Source: Bloomberg. March 31, 2009 to May 29, 2020.
Past performance is not a reliable indicator of future results.
Vanguard Global Bond Index Fund tracking error over time
Source: Vanguard. March 31, 2009 to May 29, 2020.
Past performance is not a reliable indicator of future results.
During periods of volatility, the tracking error of the fund has temporarily moved higher than its long-term average. And when the fund moved to a swing pricing model in 2017—a mechanism to protect existing investors from the impact of other investors’ trading activity—its ‘swung’ tracking error diverged from the longer-term average (we explore this in more detail later).
But over longer time horizons, tracking error has invariably fallen in line with the longer-term average once the volatility has passed.
The volatility we saw in the first quarter of 2020 reaffirms this trend. As the coronavirus pandemic caused volatility to spike in March, sellers inundated the market as they sought to reduce risk in their fixed income portfolios. This led to reduced liquidity across a number of bonds, especially corporates and, as a result, fair value became more difficult to ascertain. Price differences between index funds and their benchmarks consequently increased, pushing tracking errors artificially higher.
However, it’s important to note that these pricing differences do not accumulate, and should smooth out over the longer term. As trading and liquidity have normalised, these differences have faded. And while it might be more difficult to price bonds during market turmoil, it is still possible. Vanguard uses multiple pricing providers, which allows for an accurate reflection of current market conditions—even during volatile times.
Actively managing index portfolios
Managers of fixed income index funds seek to replicate the index as closely and cost-effectively as possible. While this might sound simple, managing a bond index fund is in many respects a very active process.
Some equity index funds fully replicate their benchmarks, purchasing every share in the index according to its relative weight. But bond markets are different. For one, the benchmarks are often much broader, making it impractical (not to mention costly) to fully replicate. In many cases, the underlying bonds are simply not available for purchase.
For this reason, Vanguard uses a replication approach known as sampling for most of its bond index funds. The sample aims to match the characteristics of the index and track its returns, without necessarily buying all the securities in the index. But this is not straightforward. It requires experienced teams of specialists to evaluate the creditworthiness and relative value of both corporate and government bond issuers. Performing this in-depth credit research allows Vanguard to achieve the optimal trade-off between cost and replication.
As well as cost-effectively tracking the benchmark, actively monitoring bond index funds can also help manage liquidity during periods of heightened volatility. Vanguard’s fixed income portfolio management team continuously assesses market conditions, buying and selling bonds to recalibrate portfolios whenever necessary, not just at month-end.
This prepares the fund for the higher-than-usual redemptions that are to be expected when markets are more volatile. In practice, this can often lead to a higher concentration of sampling in more liquid securities, which can temporarily increase the tracking error. But managing liquidity in this way helps us to minimise transaction costs so investors are not penalised by selling less liquid securities (with wider spreads) when redemptions do take place.
We believe that in more volatile markets, the most efficient way to manage fixed income index portfolios for investors is to strike the right balance between tracking error and liquidity.
Protecting existing investors with swing pricing
As one might expect, as market volatility increases, investors tend to invest in or redeem from funds more frequently. And this is often the same time that liquidity is lower. As a result, transaction costs for the fund can increase. But there is a way to reduce the impact of these costs on investors who are not transacting at these times.
To protect existing investors in a fund from the costs incurred when other investors are buying or selling, Vanguard uses a process called swing pricing. This involves adjusting the net asset value (NAV) of the fund to reflect the costs incurred by purchases or redemptions in the fund. This means the costs of transacting are borne by the investors who are trading in and out of the fund, rather than by existing investors in the fund.
Vanguard’s Swing Pricing Committee continuously and independently monitors the swing pricing factors and proactively manages them to reflect the current market environment, in order to protect investors from dilution due to the trading activity of other investors. These swing factors can increase the volatility of listed NAVs, which in turn artificially elevates the tracking error. However, this increased tracking error does not always reflect the true tracking error based on the management of the fund, and it tends to move back to previous levels once the volatility has calmed.
New issuance, upgrades and downgrades
New debt hitting the market and changes in credit ratings can also temporarily impact tracking errors. Bond issuance as well as ratings upgrades and downgrades can occur at any time, often outside of month-end rebalancing.
As Vanguard employs a sampling approach, our team of global credit research analysts and traders takes part in new bond issues, buy bonds when they are upgraded (and eligible for index inclusion) and sell bonds when they are downgraded (and removed from the index), often before the index changes are implemented at the month-end rebalancing date.
This can temporarily increase tracking error. However, this is typically short-lived, and is more than offset by the opportunity to better position the fund by buying or selling bonds at more attractive prices, which in turn benefits investors.
Taking a long-term perspective
For investors in fixed income index funds, tracking error is a key consideration. As we have seen, there are steps that index fund managers can take to ensure consistent performance relative to benchmarks.
While tracking error can also be temporarily impacted by external factors—such as during the recent period of market turmoil—it’s important to bear in mind that this tends to smooth out over the longer term, once the volatility has passed. In the example earlier of the Global Bond Index Fund, the long-term tracking error (swung) measured since the fund’s inception in March 2009 is just 0.18%.
What’s more, investors in bond index funds should balance tracking error alongside other important factors, such as rigorous and analysis-driven portfolio construction and a focus on minimising costs.
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