Bond index fund tracking errors amid volatility
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.
Investment risk information:
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
The Funds may use derivatives in order to reduce risk or cost and/or generate extra income or growth. The use of derivatives could increase or reduce exposure to underlying assets and result in greater fluctuations of the Fund's net asset value. A derivative is a financial contract whose value is based on the value of a financial asset (such as a share, bond, or currency) or a market index.
For further information on risks please see the “Risk Factors” section of the prospectus on our website at https://global.vanguard.com
Other important information:
For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). Not to be distributed to the public. In Switzerland, for professional investors only.
The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.
Prospective investors are referred to the Funds’ prospectus for further information. Prospective investors are also urged to consult their own professional advisers on the implications of making an investment in, and holding or disposing shares of the Funds and the receipt of distributions with respect to such shares under the law of the countries in which they are liable to taxation.
Vanguard Investment Series plc has been authorised by the Central Bank of Ireland as a UCITS and has been registered for public distribution in certain EU countries. Prospective investors are referred to the Funds' prospectus for further information. Prospective investors are also urged to consult their own professional advisors on the implications of making an investment in, and holding or disposing shares of the Funds and the receipt of distributions with respect to such shares under the law of the countries in which they are liable to taxation.
The Manager of Vanguard Investment Series plc is Vanguard Group (Ireland) Limited. Vanguard Asset Management, Limited is a distributor of Vanguard Investment Series plc.
For further information on the fund’s investment policy, please refer to the Key Investor Information Document (“KIIDs”). The KIIDs for these funds are available in local languages, alongside the prospectus via Vanguard’s website https://global.vanguard.com/
For Swiss investors only
The Manager of Vanguard Investment Series plc is Vanguard Group (Ireland) Limited. Vanguard Investments Switzerland GmbH is a distributor of Vanguard Investment Series plc in Liechtenstein and Switzerland. Vanguard Investment Series plc has been authorised by the Central Bank of Ireland as a UCITS. Prospective investors are referred to the Funds' prospectus for further information. Prospective investors are also urged to consult their own professional advisors on the implications of making an investment in, and holding or disposing shares of the Funds and the receipt of distributions with respect to such shares under the law of the countries in which they are liable to taxation.
Vanguard Investment Series plc has been approved for distribution in and or from Switzerland by the Swiss Financial Market Supervisory Authority (FINMA). The Representative and the Paying Agent in Switzerland is BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich. Copies of the Articles of Incorporation, KIID, Prospectus, Declaration of Trust, By-Laws, Annual Report and Semiannual Report for these funds can be obtained free of charge in local languages from the Swiss Representative or from Vanguard Investments Switzerland GmbH via our website https://global.vanguard.com/
For Dutch Investors only
For details of the Risk indicator for the fund listed in this document, please see the fact sheet which is available from Vanguard via our website https://www.vanguard.nl/portal/instl/nl/en/product.html. The fund referred to in this document is listed in the AFM register as defined in section 1:107 Dutch Financial Supervision Act (Wet op het financieel toezicht).
BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. BARCLAYS® is a trademark and service mark of Barclays Bank Plc, used under license. Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited ("BISL") (collectively, "Bloomberg"), or Bloomberg's licensors own all proprietary rights in the Bloomberg Barclays Indices.
The products are not sponsored, endorsed, issued, sold or promoted by "Bloomberg or Barclays". Bloomberg and Barclays make no representation or warranty, express or implied, to the owners or purchasers of the products or any member of the public regarding the advisability of investing in securities generally or in the products particularly or the ability of the Bloomberg Barclays Indices to track general bond market performance. Neither Bloomberg nor Barclays has passed on the legality or suitability of the products with respect to any person or entity. Bloomberg's only relationship to Vanguard and the products are the licensing of the Bloomberg Barclays Indices which are determined, composed and calculated by BISL without regard to Vanguard or the products or any owners or purchasers of the products. Bloomberg has no obligation to take the needs of the products or the owners of the products into consideration in determining, composing or calculating the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays is responsible for and has not participated in the determination of the timing of, prices at, or quantities of the products to be issued. Neither Bloomberg nor Barclays has any obligation or liability in connection with the administration, marketing or trading of the products.
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority. Issued by Vanguard Investments Switzerland GmbH.
© 2020 Vanguard Asset Management, Limited. All rights reserved.
© 2020 Vanguard Investments Switzerland GmbH. All rights reserved.