By Andy Sparks, head of fixed income research strategies, MSCI.

Andy Sparks, head of fixed income research strategies, MSCI.

Many investors may have only a qualitative understanding of the ability of passive fund managers to track the returns of a fixed-income index. Our analysis uses tracking error to provide a quantitative measure of the ease – or difficulty – of consistently tracking an index. We find generally low to moderate tracking error across broad parts of the bond market. Our analysis also suggests that less liquid and higher volatility sectors (such as high yield) tend to have higher tracking error.

We compared returns on taxable US passively managed ETFs across ten sectors to returns on their underlying benchmarks. For each ETF, we first calculated the annual difference in returns (before fees) relative to its respective benchmark over the past seven years. We then computed the ETF’s tracking error, defined as the standard deviation of its return differences. Finally, for each sector, we picked the tracking error for the median ETF. Our sample includes some of the largest ETFs in the market, with a maximum of three ETFs per sector. ETF returns use NAV prices.

We found that ETFs invested in the government (non-mortgage-backed securities) sectors consistently tracked benchmark performance very closely, with median annual tracking error ranging from 1 to 6 basis points (bps). Tracking error on MBS, broad investment-grade and the short and intermediate credit sectors was modestly higher (ranging from 9 bps to 14 bps) than the government sectors. At 67 bps, the high-yield sector had the highest tracking error, while the long investment-grade credit sector experienced tracking error of 39 bps.

We note that tracking error within a given sector differed among the ETFs in our sample, and so median values may overstate or understate tracking error on other ETFs. For example, ETF tracking error in the high-yield sector ranged from a low of 46 bps to a high of 88 bps.

High yield and long credit were harder to track – Median tracking error over past seven years

Source: MSCI. We use annual data reported to the US Securities and Exchange Commission through Nov. 13, 2017. Different ETFs have different fiscal year reporting periods. The most recent return as of dates ranged from April 30, 2017 to Aug. 31, 2017. In categories with only two ETFs, we show the average tracking error. The returns horizon for TIPS was six years; our sample consisted of 27 ETFs.

What can explain the differences in tracking error between the different sectors? We did not attempt a detailed forensic investigation, but a good starting point for the analysis is to understand that index prices may be based on model estimates. As a result, they may differ from market transaction prices. Particularly in less liquid sectors, managers may find prices on certain bonds in the actual market to be significantly higher or lower than stated index prices.

In the most extreme case, it simply may not be possible to buy a bond; for example, if the bond is held in buy-hold portfolios that allow only limited trading (e.g., in certain insurance company portfolios). Given this possibility or the potential for an expensive transaction price, the fund manager may instead purchase securities with similar but not identical characteristics. The result is that portfolio securities may not be held in strict proportion to their weights in the index. Combined with this mismatch in weights, changes in sector spreads or market events impacting specific issuers or securities may then result in tracking error.

As shown in the figure below, projected spread volatility risk was highest in the high-yield sector; issuer (or security) specific risk was also relatively high. Both of these risk measures systematically increased with the maturity of the credit sector. In addition, liquidity conditions (as proxied by bid-ask spreads) were markedly more favourable in the government bond sector and less favourable in the credit sectors. All in all, these observations on sector volatility risk and liquidity are generally consistent with the patterns in tracking error observed in our sample of ETFs.

Bid-Ask, spread risk and specific risk

Source: MSCI.

Over the next several years, growth in e-trading and regulatory initiatives including MiFID II  may result in greater price transparency in the fixed-income market. This, in turn, could lead to improved index pricing and stronger portfolio construction tools based on better market liquidity modelling. Particularly for the less liquid parts of the bond market, these developments may help reduce tracking error and may provide investors with a better understanding of sector risk and reward trade-offs.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)