IN BRIEF

 

  • Asset flows – Investors have shown strong interest in ETFs and other passive, index-replicating bond strategies, as evidenced by asset flows.
  • Benchmark inefficiencies – There are numerous complexities and benchmark inefficiencies associated with passive holdings in fixed income that have a bearing on the risk-return profile of these investments.
  • Index composition and liquidity – Factors for consideration include the nature of the over-the-counter (OTC) bond market and issuer-weighted indices, which often means that investors seeking to replicate the index will be investing most heavily in bonds issued by the most indebted companies and countries.
  • Interest rate sensitivity – Passive investors have been taking on more interest rate risk than they were during the global financial crisis as a result of the rise in the interest rate sensitivity (duration) that has followed the fall in yields in the benchmark indices.
  • Benchmark-aware approach – We advocate a “benchmark-aware” active approach that allows a manager to incorporate the style discipline benchmarks provide, while maintaining the flexibility to make investment decisions that may help avoid the pitfalls of passively tracking the benchmark.

For some years now, investors have been seeking passive, indexreplicating bond investing strategies, including exchange-traded funds (ETFs), in an effort to emulate the success of passive equity investing. However, equity and bond indices are constructed quite differently, which has important implications for investors. Investing in fixed income indices poses a number of challenges, among them the nature of the over-the-counter (OTC) bond market and the inefficiency of fixed income benchmarks.

 

The structure of the fixed income market and the indices created to represent the opportunity set in the asset class have particular characteristics that argue for an active approach. In this paper we review these factors and make the case for an active “benchmark-aware” approach to fixed income investing.

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Investors flocking to bond ETFs

In the past few years, passive strategies, including ETFs, have attracted assets and now make up 27% of the total assets in US bond mutual funds and ETFs, up from 20% in 2011 (see Exhibit 1). While ETFs are still a small segment of the market, their weight has more than doubled, rising from 3.5% in 2011 to 8.4% by the end of 2015. Investors see these instruments as offering quick, easy access to the markets, as well as liquidity and low management fees.

mfse_whyactv_wp_4_16 Exhibit_1

Benchmark inefficiencies

There is a perception among some investors that bond ETFs pose little risk; however, this is far from accurate. Bond ETFs often track the Barclays indices, a family of broadbased fixed income benchmarks first published by Lehman Brothers in 1973, when active bond investing was in its infancy.1 Fixed income products have become much more complex in the intervening years, and index providers have responded with a proliferation of subindices, custom indices and new weighting schemes.

 

Since an index defines the universe of securities in which a manager may invest, which index is chosen has a direct bearing on the portfolio’s risk exposures and relative performance drivers. For these reasons, investors are well served by understanding the makeup of the benchmark index for any given investment strategy, including ETFs. Essentially, investors need to know what the index actually contains in order to have a reliable view of their holdings. This is particularly important in fixed income because the benchmark indices have particular structural inefficiencies that impact the risk profile and returns of a portfolio.

OTC trading/liquidity issues

The way fixed income is traded over the counter is a complicating factor for benchmarks. The bond market is almost exclusively a dealer market: An investor buys bonds from a dealer and sells the bonds back to the dealer on negotiated terms. There are no exchanges with posted prices. As a result, many securities, especially corporate issues, are difficult to trade and price effects can be material. Larger issue size is usually a significant advantage in the execution of trades.

 

The OTC nature of the bond market means that periods of poor liquidity can have a meaningful impact on passive strategies, which are forced to replicate an index and therefore have to purchase bonds regardless of pricing. This effect is amplified in a low-rate environment, where every quarter point makes a difference. The reduction in dealer inventory in the wake of regulatory changes following the global financial crisis has led to reduced liquidity in some instances.

 

In addition to liquidity, the sheer size of broad market indices is a consideration. Tracking the indices can be difficult for portfolio managers, whether through sampling or full replication. For instance, the Barclays U.S. Aggregate Index has more than 1,000 unique issuers and more than 9,000 issues, making it almost impossible to fully replicate. This means that passive managers have to make “active” investment decisions as they decide which securities to include in their representative portfolio. For example, the iShares Core U.S. Aggregate Bond ETF contains just under 5,000 issues as of 31 December 2015.

The issue-weighted problem

The foundation of an index is its weighting scheme. The overwhelming majority of indices — both equity and fixed income — are market-capitalization weighted. This weighting scheme was originally developed for equity indices as a way to reflect the broad equity market.2 In equity indices, the market determines the weights; in bond indices, however, weightings are largely determined by issue size and debt outstanding. Passive managers have to make “active” investment decisions as they decide which securities to include in their representative portfolio. Bond indices are driven by how much debt a company or sovereign decides to issue and the size of the individual security issued. Consequently, investors seeking to replicate the index will be investing most heavily in bonds issued by the companies and countries that are most dependent on external financing. Many may still have strong balance sheets, but there is a risk that passive bond investors could be buying the “biggest losers.” In contrast, in a market-capitalization-weighted equity index, investors typically own the “winners,” i.e., the companies that have grown in market capitalization due to their success. The issuer-capitalization methodology inherent in bond indices is counterintuitive in many respects. Investing in a bond index can result in holding the debt of the most highly leveraged issuers, with the attendant risks this poses.

Passive managers have to make “active” investment decisions as they decide which securities to include in their representative portfolio.

Interest rate sensitivity rises

A further complication is that as yields have fallen, duration (interest-rate sensitivity) has increased for the indices, Bond indices are driven by how much debt a company or sovereign decides to issue and the size of the individual security issued. Investing in a bond index can result in holding the debt of the most highly leveraged issuers, with the attendant risks this poses.with the effect that investors are now taking more interest rate risk than they were during the global financial crisis in 2008. Exhibit 2 charts the trajectory of duration relative to yield for the Barclays U.S. Aggregate Index, revealing a notable divergence, the effect of which is a fall in the yield per unit of duration shown in Exhibit 3. The decline in yield per unit of duration indicates that investors are receiving lower compensation per unit of interest rate risk for their investments in fixed income indices.

Bond indices are driven by how much debt a company or sovereign decides to issue and the size of the individual security issued. Investing in a bond index can result in holding the debt of the most highly leveraged issuers, with the attendant risks this poses.
mfse_whyactv_wp_4_16 Exhibit_2
mfse_whyactv_wp_4_16 Exhibit_3

A similar Investors are now taking more interest rate risk than they were during the global financial crisis in 2008.fall in yield per unit of duration has occurred in the European and global indices. Exhibit 4 depicts the decline in the United Kingdom, Germany and France, while Exhibit 5 shows the same trajectory for the Barclays Global Aggregate Index.

Investors are now taking more interest rate risk than they were during the global financial crisis in 2008.
mfse_whyactv_wp_4_16 Exhibit_4
mfse_whyactv_wp_4_16 Exhibit_5

Another consideration is that the duration of a benchmark comes from issuer preferences regarding the term structure of issuance and is not necessarily the duration that a given investor should hold. The optimal portfolio duration for an investor should be a function of his or her time horizon and risk profile, rather than that of the index. Said another way, duration can be thought of as exposure to the interest rate factor. In this context, choosing an appropriate bond portfolio duration is essentially an asset allocation decision, which investors should make based on their particular circumstances.3

Composition and new issue market size

The composition of the indices is also an important factor that potential passive ETF investors should consider. The increase in bonds issued by the US Treasury in the wake of the global financial crisis has led to a rise in the proportion of Treasuries in the Barclays U.S. Aggregate index (see Exhibit 6). This is one of the reasons yields per unit of duration have fallen in the benchmark indices.The decline in yield per unit of duration indicates that investors are receiving lower compensation per unit of interest rate risk for their investments in fixed income indices.

The large size of the new issue market in fixed income relative to equities is a further consideration. The annual turnover in the corporate bond market is approximately 20%, versus a little over 1% for the equity market. This makes sense, as a common equity is usually a long-term perpetual security, whereas bonds have finite maturities. This adds an additional level of complexity and increased trading cost when a manager is seeking to track the benchmark. The impact of new issuance can have a significant impact on the composition of an index. For example, the US energy sector increased its issuance of new high-yield debt such that the weight of energy in the Barclays High Yield Index has increased from 3.9% in 2004 to 11.1% currently (2 March 2016).

The decline in yield per unit of duration indicates that investors are receiving lower compensation per unit of interest rate risk for their investments in fixed income indices.
mfse_whyactv_wp_4_16 Exhibit_6

The benchmark-aware approach

As we have highlighted, there are numerous inefficiencies and complexities related to investing in fixed income indices that passive ETFs take on when they track a bond index. We do not support jettisoning benchmarks, as some managers of unconstrained fixed income strategies have done.

 

Rather, we advocate a benchmark-aware approach to active investing that allows a portfolio manager to incorporate the style discipline benchmarks provide along with an appropriate level of flexibility to make suitable investment decisions.

 

In our view, the adoption of a benchmark-aware approach can provide the appropriate structure — the guardrails, if you will — to enable fixed income investments to behave as they are usually intended, i.e., as ballast in a well-diversified portfolio, while avoiding the pitfalls of an approach that hugs the benchmark. In this case, a benchmark becomes a risk barometer to evaluate a manager’s risk profile, rather than an investment blueprint, and allows for active management of the risk budget. We advocate a benchmark-aware approach to active investing that allows a portfolio manager to incorporate the style discipline benchmarks provide along with an appropriate level of flexibility to make suitable investment decisions.

 

 

Active strategies within fixed income allow managers to broaden the opportunity set and allocate across sectors to find better credits — and also avoid poor credits. The asymmetrical nature of bond returns — also referred to as negative skew — means that in bond management one wins by playing strong defense, that is, by avoiding the problematic credits that default on payments.4

 

Active managers can work to mitigate credit risk, interest rate risk, debt concentration, liquidity and duration-matching risk in ways that passive managers cannot, while maintaining a benchmark-aware approach that allows investors to understand the risk profile the strategy is likely to demonstrate.

Conclusion

While interest in bond ETFs that track the benchmark indices continues to show strength, investors should be aware that fixed income indices have certain characteristics that may make them less efficient — and potentially more risky — investments. In the current lower growth economic environment, allocating capital to indices that invest most heavily in bonds issued by the companies and countries most dependent on the capital markets for financing may give some pause — appropriately so, in our view.

 

It is notable too that passive investors are now taking on more interest rate risk than they were during the global financial crisis in 2008 as a result of the rise in duration (interest rate sensitivity) that has accompanied the fall in yields.

 

We are proponents of a benchmark-aware approach to fixed income investing that provides important risk management discipline while addressing some of the issues associated with passively tracking an index.

 

We advocate a benchmark-aware approach to active investing that allows a portfolio manager to incorporate the style discipline benchmarks provide along with an appropriate level of flexibility to make suitable investment decisions.

 

 

Endnotes

1 All legacy Lehman Brothers benchmark indices were rebranded as Barclays Capital indices in November 2008.

2 Siegel, Laurence B., Benchmarks and Investment Management. Charlottesville, VA, The Research Foundation of the Association of Investment Management and Research, 2003, 89–103.
3 Ibid, p. 90.

4 An asymmetrical or skewed distribution occurs when one side of the distribution does not mirror the other. Applied to investment returns, asymmetrical distributions are generally described as being either positively skewed (meaning frequent small losses and a few extreme gains) or negatively skewed (meaning frequent small gains and a few extreme losses).

 

 

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