Vanguard bond index fund tracking error

The following tables provide tracking error data for Vanguard bond index funds. Tracking error is the ultimate measure of judging an index fund manager’s performance. Since bond indexes can include huge numbers of illiquid bonds, replicating an index is often very costly. Vanguard, in an attempt to control costs, samples securities in their bond index funds. The sampling attempts to match the sector and risk metrics of the underlying bonds in the index. Because a sampled index fund does not hold all of the securities in the underlying index, its returns may vary somewhat from those of the index. Such performance variance is termed “sampling error.”

The funds originally employed a corporate bond substitution policy, whereby they substituted short term corporate bonds for treasury bonds in fund holdings. The funds’ substitutions were limited to securities with less than 4 years remaining to maturity, and were restricted to a maximum of 15% of total assets. The rationale for substitution was that the higher interest income from corporate issues would help the funds offset the costs of implementation and would, with a moderate increase in diversifiable risk, allow the funds to more closely track their benchmark indices.

In 2002, a substantial increase in market risk and defaults hit the corporate bond market. As a result of the corporate substitution policy, the Vanguard bond index funds failed to closely track their benchmark indices. The funds held higher than benchmark weightings of telecommunication and energy company bonds, both of which were hurt by defaults and credit quality erosion. The short term, intermediate term, and total bond portfolios all lagged benchmark returns by over 2.00% for the year.

Vanguard initially responded to the performance lag by reducing the allowable corporate substitution in the funds to a maximum 10% of net assets. By early 2005 the funds adopted a sampling strategy that required the funds to more tightly sample not only industry sectors, but also to tightly sample industry subsectors. In 2009, as a result of the 2008-2009 financial crisis and the expansion of Federal Reserve purchasing of mortgage backed and other debt market securities, the Vanguard bond funds adopted free float versions of the Barclay bond indices as benchmark indices.

The charts below illustrate investor share tracking error, which records the 2002 tracking error short-fall.  Investor shares were discontinued in 2019.

Short Term Bond Index

Historical annual tracking error data for admiral shares. Investor shares, as of 2019 are discontinued. Investor share data is available on the fifth tab of the spreadsheet.

Intermediate Term Bond Index

Historical annual tracking error data for admiral shares. Investor shares, as of 2019 are discontinued. Investor share data is available on the fifth tab of the spreadsheet.

Long Term Bond Market

Historical annual tracking error data for investor shares. Admiral shares were introduced  for this fund in 2019.

Total Bond Market Index

Historical annual tracking error data for admiral shares. Investor shares, as of 2019 are discontinued. Investor share data is available on the fifth tab of the spreadsheet.

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