Running this bond ETF is like solving a $55 billion Rubik’s Cube

The world's biggest bond ETF tracks a benchmark that contains 9,917 bonds, many of them illiquid.

If you think running a passive bond fund is a formulaic task that a robot could do, think again.

When your underlying index is filled with thousands of fixed-income securities, tracking it isn’t exactly a simple task. The crux of the problem: It’s essentially impossible to own every note and bond in the benchmark. If you therefore use a selection of its constituents to replicate the benchmark, you have to continually tweak the characteristics of your optimized portfolio to home in on the performance of the underlying index.

BlackRock Inc.’s Jasmita Mohan and Karen Uyehara know all about it.

The two women, who sit next to each other at BlackRock’s San Francisco office, have for the past four years run the world’s biggest bond exchange-traded fund: BlackRock’s $55 billion iShares Core U.S. Aggregate Bond ETF. AGG — its ticker, by which the fund is commonly known — seeks to mirror returns of the Bloomberg Barclays US Aggregate Bond Index.

“At the end of the day, there’s a lot of active decisions that go into creating a portfolio that can truly replicate the benchmark,” said Ms. Mohan, 33, who worked on the development of the company’s risk-management platform in addition to running multisector debt funds such as AGG.

Over the three years through May 18, the Bloomberg Barclays index returned 1.13% annually. AGG returned 1.04% a year. That’s a difference of 0.09 percentage points. For five years, the difference is 8 basis points, according to data compiled by Bloomberg.

A few simple stats give a sense of why the AGG managers need to make so many choices to track their bogey. The Bloomberg Barclays index included 9,917 bonds as of May 17. The ETF, meanwhile, held 6,760 debt instruments.

Keeping returns almost in lockstep with one-third fewer securities is all about sampling: choosing the overall number of positions and selecting the specific notes and bonds to hold while also minimizing transaction costs. In a universe of almost 10,000 bonds, many are illiquid. They’re thus more costly to deal in and difficult to buy and sell in small sizes.

“For a variety of reasons in fixed income, you just can’t buy everything in the underlying index,” said Ms. Uyehara, 46, who prior to joining BlackRock in 2010 was a portfolio manager at Western Asset Management Co. “Our sampling method enables us to track the broad risk factors of the fund’s benchmark.”

It’s like a big Rubik’s Cube of sampling, with each piece representing different risk factors in the underlying benchmark index, Ms. Uyehara said. For each risk-factor bucket, the team picks a selection of bonds of various maturities, ratings, and other characteristics — but they need to keep in mind all along how a change in one face will affect the others. When all of those moves come together to generate fund returns near the index, it’s like solving the cube.

Passive-fund managers aren’t given enough credit for what they do, said Ben Johnson, director of global ETF research at Morningstar Inc. “Index fund portfolio managers are kind of like the Rodney Dangerfields of the asset management world,” he said. “They don’t get no respect.”

Yet the work of index fund managers is extremely complicated, Mr. Johnson said — particularly when it comes to managing bond portfolios. Such managers deal with “a bunch of trade-offs trying to replicate the benchmark as completely as possible, while managing that against what are real and in some cases material transactions costs.”

In teaming up to work on AGG, Ms. Mohan and Ms. Uyehara bring complementary finance backgrounds. Ms. Mohan is a quantitative guru, having earned a bachelor’s degree in computer engineering from Netaji Subhas Institute of Technology in New Delhi and a master’s in engineering management from Duke University. Ms. Uyehara had a broader focus in school, with a dual undergraduate degree in history and economics from the University of California at San Diego and an MBA from the University of Southern California.

Collaboration doesn’t stop with just the two managers, though. They reach out regularly to at least eight other BlackRock fund managers who are experts in various debt sectors and do the granular picking of individual securities. That’s important given the multisector nature of AGG’s benchmark.

The Bloomberg Barclays index includes instruments from a wide range of bond types: As of May 8, it was 37% U.S. Treasuries, 28% pass-through mortgage-backed securities, 15% corporate bonds issued by industrial companies, 8% financial corporates and 3% agencies, with smaller amounts of commercial mortgage-backed securities, utility, supranational, sovereigns, local authority, asset-backed securities, and covered bonds.

“Jasmita and I are responsible for the overall risk of the fund, taking a 10,000-foot view,” Ms. Uyehara said. “We do the asset allocation to our different sector teams, who then do a more bottom’s-up approach with the security selection. It’s really a big team effort to run the AGG.”

On a typical day, Ms. Mohan and Ms. Uyehara get into BlackRock’s office at about 5:30 a.m. PT, around the start of trading in New York. They usually head out about 10 hours later. The multisector teams keep similar hours and sit within “across-the-desk shouting distance,” Ms. Uyehara said. Ad hoc discussions are a common occurrence.

Although trades are done all the time, the peak of execution comes at month’s end, when the Bloomberg Barclays Indices rebalance (making adjustments for new debt issued to be added or securities to be removed). The day prior, Ms. Mohan and Ms. Uyehara prepare a full list of buy and sell orders for the team.

If all this didn’t already seem hard enough, passive-fund managers — unlike their peers at the helm of actively run portfolios — aren’t rewarded by investors for hitting home runs relative to the indexes they are mandated to track. The opposite is actually true. If a passive fund outperforms, investors typically are wary that the managers may be exposing them to undue risks.

That raises a dilemma that some active managers might envy. “It isn’t easy to not outperform the index, either,” Ms. Mohan said. “We are very mindful of the fact that we have to deliver on our fiduciary responsibility. In this case, it happens to be tracking the benchmark as closely as possible.”