Cindy Cheng, a Hong Kong-based portfolio manager, has established the All Asia Dragon Fund, a fixed-income fund designed to outperform the Markit iBoxx Asian Local Bond Index (ALBI). The ALBI tracks the total return performance of liquid bonds denominated in local currencies in the following markets: Chinese mainland, Hong Kong SAR, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan region, and Thailand. The index includes both government and non-government bond issues, with constituent selection criteria by government as well as weights designed to balance the desire for liquidity and stability (“Markit iBoxx ALBI Index Guide,” January 2016, Markit Ltd). 

Individual bond weightings in the index are based on market capitalization, and market weights, reviewed annually, are designed to reflect the investability of developing Asian local currency bonds available to international investors. These weights are driven by local market size and market capitalization, secondary bond market liquidity, accessibility to foreign investors, and development of infrastructure that supports fixed-income investment and trading, such as credit ratings, yield curves, and derivatives products.

Given the large number of bonds in the index, Cheng uses a representative sample of the bonds to construct the fund. She chooses bonds so that the fund’s duration, market weights, and sector/quality percentage weights closely match the ALBI. Given the complexity of managing bond investments in these local markets, Cheng is targeting a 1.25% tracking error for the fund.

One of Cheng’s largest institutional investors has encouraged her to reduce tracking error. Suggest steps Cheng could take to minimize this risk in the fund.