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When passive fixed income funds don’t create a passive portfolio

By: Jim Rowley, Vanguard Global Head of Investment Implementation Research

In a previous post, A new form of active investing?, I wrote about how investors use individual U.S. equity index funds to create active equity portfolios. In short, investors use passive funds to build portfolios that look more like active.The natural follow-up question is: Would we find the same thing for U.S. fixed income? 

Rather than buying one aggregate bond index fund that tracks the broad U.S. fixed income market, are investors trying to build bond portfolios that track the broad bond market by holding targeted index funds that track specific sectors of the bond market, such as corporates, U.S. Treasuries, or mortgage-backed securities? 

Among those who are holding index funds that target a specific segment of the bond market, we found that the effect of this decision is that those investors are much more likely to be using these index funds to take active positions against the market. To successfully maintain a passive portfolio using targeted index funds, you must weight these funds according to the segments they are tracking in their market-capitalization proportion to the total market.

This is not easy to do in fixed income―particularly U.S. dollar-denominated fixed income―because the asset class is heterogeneous and there isn’t an agreed-upon definition of the total market. For example, should the total market include taxable as well as tax-exempt fixed income; should it include investment-grade as well as high-yield fixed income? Should Treasury Inflation-Protected Securities be included?

Passive fixed income funds building active portfolios

As investment professionals, we looked at this question from a practitioner’s standpoint and used the Bloomberg U.S. Aggregate Bond Index as a proxy for the total U.S. bond market. It captures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market with maturities of at least one year. To get a sense of how the dynamic plays out, we compared the performance of this benchmark with that of three types of bond funds―bond index funds whose objective is to track the total market (“Total Market Index Funds”), bond index funds with an objective to track an index other than the total U.S. bond market (“Non-Total Market Index Funds”), and traditional actively managed bond funds (“Active Funds”).

Non-Total Market Index Funds don’t track the total bond market


Notes: The chart shows the excess return for Non-Total Market Index Funds, Total Market Index Funds, and Active Funds relative to the Bloomberg U.S. Aggregate Bond Index. Non-Total Market Index Funds, Total Market Index Funds, and Active Funds are each a portfolio of funds that have existed at any point during the period in the following Morningstar U.S. taxable bond categories: Long-Term Government, Intermediate-Term Government, Short-Term Government, Long-Term Bond, Intermediate-Term Core Bond, Short-Term Bond, Corporate Bond, Target Maturity, and Emerging Markets Bonds. Non-Total Market Index Funds comprise funds labeled as “index funds” but exclude those index funds whose prospectus benchmark is the Bloomberg U.S. Aggregate Bond Index, including its float-adjusted version. Total Market Index Funds comprise funds labeled as “index funds” whose prospectus benchmark is the Bloomberg U.S. Aggregate Bond Index. Active Funds include those funds not labeled as “index funds.” The monthly return for each of Non-Total Market Index Funds, Total Market Index Funds, and Active Funds is calculated as the monthly cross-sectional asset-weighted return whereby each fund’s current-month gross return is weighted by its prior month’s assets under management as a proportion of the sum of the prior month’s assets under management for all funds in the portfolio.

Source: Author’s calculations, using data from Morningstar, Inc., from January 2000 through December 2022.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

We studied the monthly excess returns of these funds relative to the Bloomberg U.S. Aggregate Bond Index from 2000 through 2022. As expected, Total Market Index Funds seem to provide truly passive exposure to the total market, given how closely the performance of these funds hovers around a value of zero. Also as expected, Active Funds have very noticeable deviations from zero, suggesting active exposure. But what’s interesting is that the Non-Total Market Index Funds, or those that try to track specific segments of the bond market, perform like active funds by also deviating noticeably from the Aggregate, a finding consistent with what we found in equity funds. The deviations might not be quite as large as with Active Funds, but they are certainly greater than with Total Market Index Funds. This suggests active exposure.

Even though the Non-Total Market Index Funds we examined technically are passively managed, these funds in aggregate don’t provide passive exposure at the portfolio level. This doesn’t mean that using bond index funds that track specific segments of the market to build active portfolios is a bad idea. To the contrary; it may be a worthwhile strategy in many cases. What our research does mean is that investors should not rely solely on classification labels, such as “index” or “active,” as they can overlook the investment exposures of those funds. Actively considering a portfolio’s aggregate investment exposure shouldn’t be a passive decision.




All investing is subject to risk, including the possible loss of the money you invest.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.


“Bloomberg® and Bloomberg U.S. Aggregate Bond Index are service marks of Bloomberg Finance LP and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Vanguard.


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