In a perfect world, a reasonable person would hope that the net
asset value ((
)) of an exchange traded fund ((
)) would equal the index return minus the expense ratio. The
difference is called the tracking error.On this basis, it's
interesting when a fund exceeds that benchmark and raises the
question: how do they do that?
For the three years ending June 14th, 2011, the Barclays
Aggregate Bond Index (
) has earned 6.95 percent according to Morningstar. The Vanguard
Total Bond (
) fund charges an expense ratio of 0.11 percent, so a reasonable
investor would expect the NAV to have gained by 6.83 percent (that
extra basis point is due to compounding: (1.0695 / 1.0011)-1 =
0.0683 = 6.83 percent).
According to Morningstar, however, the NAV for BND was actually
6.94 percent - one basis point away from the index! What explains
Normally, these differences are chalked up to trading
techniques. This is true, but also not particularly descriptive, so
it might be interesting to investigate one strategy more
Let's start with the fact that while Vanguard seeks to fully
replicate the AGG, there are some practical limitations that make
100 percent perfect replication of the 7,989 bonds in the index
Vanguard has almost 5,000 individual bond positions, which is
short of the index, but well more than any of its competitors
tracking this index that mostly have less than 1,000 bonds.
If anyone could fully replicate, it would be Vanguard, thanks to
their patented share class structure. To the extent that they can't
fully replicate, they have to make some optimizing decisions.
Consider the corporate bond sector allocation, which may be one
of the hardest areas to fully replicate due to the illiquidity of
some of the individual bonds. Here, Vanguard is able to replicate
approximately 90 percent of the sector, but can't efficiently
replicate 100 percent.
For the remaining 10 percent or so that can't be replicated,
Vanguard uses their team of credit analysts to add a one or two
basis point overweight to issues that the analysts view as
improving and subtracts one or two basis points to underweight
names that they believe aren't as attractive.
These slight over and underweights do not change the character
of the fund - the curve still matches, the credit rating and
quality still matches, the sectors still match, etc. Even with
these small optimization decisions, there are no active tilts in
Vanguard says that their risk models indicate that on an ex ante
basis, the tracking error will be extremely tight, somewhere around
five basis points. Over the past three years, it's been better than
their models would have predicted and been in favor of the fund
I am long BND. The views expressed do not necessarily represent the
views of Acropolis Investment Management, LLC. or its members.
Clients of Acropolis own BND as a core holding and we are regularly
buying and selling BND for clients as part of our portfolio
Looking at Verizon's Historical Dividend Yield