Explain how bond indexes are built and why managing a portfolio to track one is hard
The idea
Bond indexes contain thousands of issues, many thinly traded, so buying every bond is rarely practical. Composition changes constantly as bonds mature, are called and are issued, and weighting by debt outstanding means the most indebted issuers carry the largest weights. Many bonds have no recent trade, so indexes rely on evaluated prices. Managers therefore match the index's primary risk factors rather than its holdings: duration and key rate durations, sector and quality weights, issuer exposure, cash flow distribution and convexity. Transaction costs are high and dealer liquidity uneven. The trap is matching overall duration while ignoring differences in spread duration and key rate profile, which then show up as tracking error.
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