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Rethinking sovereign debt

Institutional investors turn to customized indexes for government bonds

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Rethinking: Dominic Pegler believes investors are building bond benchmarks in a new way.

Institutional investors are turning to customized indexes for their passive government bond investing, a trend likely to gain more traction as sovereign credit risk in the developed world increasingly comes under scrutiny.

Since Greece's debt problems began to surface two years ago, executives at pension funds, insurance companies and sovereign wealth funds have been looking for ways to tailor their sovereign debt exposures to better match investment goals. More recently, credit downgrades of “risk-free” government bonds, including those issued by the U.S. and France, have caused more worries for investors.

The move away from market-weighted government bond indexes is not new. There have been some occasions when investors have wanted to tailor exposures; for example, limiting investments in Japanese bonds was an important theme about 15 years ago, sources said.

“What's different recently is the scale of it,” said Dominic Pegler, managing director and head of fixed-income product strategy at BlackRock (BLK) Inc. (BLK) based in London. “Investors are having to rethink the way that they're building (fixed-income) benchmarks, in a way that they have never had to do before in the credit world.”

At BlackRock, customized fixed-income indexes are used for about 20% of the $60 billion managed in passive European fixed-income strategies, Mr. Pegler estimates. Two years ago, that figure was negligible.

Industrywide data for assets invested in custom fixed-income indexes are not available, but several of the largest passive fixed-income managers said they are seeing an uptick in the number and size of such mandates. According to an EDHEC-Risk European Index Survey published in October, about 17% of the respondents said they used alternative-weighted government indexes.

Demand for “actively designed, passively managed” strategies is a key trend, said David Rothon, London-based senior vice president and director of cash and fixed-income products in the asset management division of Northern Trust Corp. The firm manages about $68 billion in passive fixed income globally, about $48 billion of which is invested in customized indexes.

“It's empowering investors to own their own benchmarks,” Mr. Rothon said. “At the asset allocation level, investors can set what exposures they want and build their investment objectives into a benchmark.”

For example, one Dutch pension fund worked with Northern Trust to tailor a government bond index that would include a 30% exposure to domestic government bonds, compared to an estimated 2% allocation to the Netherlands in a typical euro-denominated government bond index, Mr. Rothon said. He would not identify the client.

“Investors are looking more holistically across asset allocation, unshackling themselves from traditional index rules,” Mr. Rothon said.

Catching up

While European institutions have been ahead of the pack in customizing government bond indexes, some U.S. investors also are beginning to adopt credit quality screens and other forms of benchmark tailoring, managers said. “We're also getting a lot more phone calls from clients in Asia in the last six months,” Mr. Rothon added.

The degree of index customization varies widely and has included tailoring a fundamentally weighted bond index, which was introduced to steer investors away from market-weighted indexes in the first place.

In a typical market-weighted global government bonds index, countries that issue the most debt have the largest weighting.

“What makes more sense is to measure a country's ability to service debt,” said Shane Shepherd, vice president and head of fixed-income research at Research Affiliates LLC, Newport Beach, Calif. The firm, along with Citigroup Inc., introduced a new set of indexes — Citi RAFI Sovereign Bond Index Series — in January. The indexes equally weight four factors: gross domestic product; population; energy consumption; and land area.

Seven months earlier, BlackRock (BLK) introduced its Sovereign Risk index, which can be modified to meet institutional investment goals. The BlackRock index ranks countries based on a comprehensive set of factors that affect credit quality, including debt-to-GDP ratios, demographic profile, proportion of domestically held debt, and growth and inflation volatility. Within the index, South Korea, Chile, Australia, Canada and some Northern European countries currently rank above Germany. China is ahead of the U.S., while Portugal, Greece and Ireland are all in the bottom 10 of the 44 countries in the index.

“The world has changed, and investors want to build a portfolio that reflects these changes,” Mr. Pegler said. BlackRock manages about $575 billion globally in total passive fixed-income assets. Performance data for custom indexes are not available because the indexes vary widely among clients, making it difficult to compare on an industrywide level.

Cheaper than active

Depending on the level of complexity, investors might have to pay a premium for custom indexes, but any additional cost is substantially less than an active strategy. As a result, not all passive managers agree that clients can benefit from custom indexes in the long term.

“Investors can't defend against every risk when taking a long-term perspective” to investing, said Jeffrey S. Molitor, principal and chief investment officer in Europe at Vanguard Group Inc., based in London. “Our sense is that a lot of what's happening (in customized indexes) is reactive in the same way that investors are trying to play the "switch on, switch off' strategy. They may be switching at the wrong time.”

“We think investors are best served by the opportunities within the (existing) index,” Mr. Molitor added.

Bill Street, London-based global head of fixed-income alpha strategies at State Street Global Advisors, said customized indexes are attracting investors who believe market-weighted indexes are inherently flawed. “The issue isn't actually about passive investing, the issue is the underlying construction and the basis of the market exposure,” he said.

Since the first quarter of 2011, Mr. Street said more clients in Europe have been asking for more tailored benchmarks, often excluding certain countries such as Italy, Spain, Greece, Ireland and Portugal. In doing so, clients sacrifice yield for a portfolio likely to be less volatile with improved liquidity, he said.

SSgA is also planning to launch an alternative-weighted sovereign bond index that balances fundamental factors and more market-driven factors such as liquidity and term structure.

“There has been a step change in the past year,” Mr. Street said. “Clients are looking at sovereign bonds with a lot more skepticism and anxiety, and that's not going to change anytime soon, especially in Europe.”

SSgA has about $270 billion in passive fixed-income assets under management globally.

Concern over biases

In a survey sponsored by Northern Trust and conducted by Greenwich Associates that is to be released this month, 37% of the respondents globally said they were concerned or very concerned about the biases in standard indexes, including that toward larger debt issuance in a market-weighted fixed-income index. The level of skepticism is higher among Asian investors, with 52% of the respondents expressing concern about index bias.

According to an analysis of the survey: “With the increasing overhang of debt issues in Europe and in other parts of the developed world, many investors see emerging markets and Asia as the source of growth in the future.”