Why is it difficult to build a portfolio in pursuing a pure bond indexing strategy?

What will be an ideal response?

Althoughit is not simple to build a portfolio for enhanced indexing strategies, it is even more difficult to implement a pure bond indexing strategy. These grave difficulties apply to both the cell-based and multi-factor model approaches to portfolio construction. Below we attempt to describe why.

In a pure bond indexing strategy, the portfolio manager must purchase all of the issues in the bond index according to their weight in the benchmark index. However, substantial tracking error will result from the transaction costs (and other fees) associated with purchasing all the issues and reinvesting cash flow (maturing principal and coupon interest). A broad-based market index could include more than 6,000 issues, so large transaction costs make this strategy impractical. In addition, some issues in the bond index may not be available at the prices used in constructing the index.

Instead of purchasing all issues in the bond index, the manager may purchase just a sample of issues using the cell-based approach. This moves the strategy from being a pure bond indexing strategy to an enhanced bond indexing strategy with minor mismatches in the primary risk factors. Although this approach reduces tracking error resulting from high transaction costs, it increases tracking error resulting from the mismatch of the indexed portfolio and the bond index. In practice, managers who state that they pursue a "pure" bond indexing strategy typically are forced to follow an enhanced bond indexing strategy with minor mismatches in the primary risk factors.

A portfolio manager faces several other logistical problems in seeking to construct an indexed portfolio. First, the prices for each issue used by the organization that publishes the index may not be execution prices available to the indexer. In fact, they may be materially different from the prices offered by some dealers. In addition, the prices used by organizations reporting the value of indexes are based on bid prices. Dealer ask prices, however, are the ones that the manager would have to transact at when constructing or rebalancing the indexed portfolio. Thus, there will be a bias between the performance of the bond index and the indexed portfolio that is equal to the bid-ask spread.

Furthermore, there are logistical problems unique to certain sectors in the bond market. Consider first the corporate bond market. There are typically about 3,500 issues in the corporate bond sector of a broad-based index. Because of the illiquidity of this sector of the bond market, not only may the prices used by the organization that publishes the index be unreliable, but many of the issues may not even be available. Next, consider the agency mortgage-backed securities market. There are more than 800,000 agency pass-through issues. The organizations that publish indexes lump all these issues into a few hundred generic issues. The portfolio manager is then faced with the difficult task of finding pass-through securities with the same risk–return profiles of these hypothetical issues.

Finally, recall that the total return depends on the reinvestment rate available on coupon interest. If the organization publishing the index regularly overestimates the reinvestment rate, the indexed portfolio could underperform the bond index by a significant number of basis points
a year.