VicSuper's new index takes knife to U.S., Japan bond exposures

The A$9.2 billion (US$9.7 billion) Melbourne-based VicSuper has adopted a customized index for its passive bond investments, dropping its market-cap-weighted index in favor of one with less exposure to the U.S. and Japan.

Market veterans expect a growing number of Asian institutional investors to take similar steps to better diversify their sovereign bond allocations.

The defined contribution superannuation plan adopted a benchmark designed with the fund's investment partners, capping holdings of any single country's sovereign bonds at 10% of VicSuper's overall sovereign bond allocation.

That upper limit represents a sharp cutback for countries such as the U.S. and Japan, which account for 30% each of the sovereign bond allocations in market-cap-weighted indexes such as the Barclays Capital Global Aggregate benchmark previously used by VicSuper.

The switch to the custom benchmark was prompted, in part, by concerns about “the considerable concentration risk” of the Barclays Global Aggregate's roughly 60% allocation to sovereign bonds, Ronan Walsh, portfolio manager-fixed income with VicSuper, said in an e-mail.

VicSuper's new approach will go a long way toward addressing the investment team's concerns about the “concentration and default risks in the government bond market” now, Mr. Walsh said in a telephone interview.

The era of market-cap-weighted bond indexes that changed gradually enough to let investors sleep soundly at night ended in 2007, noted Peter N. Horn, executive director and head of J.P. Morgan Asset Management (JPM)'s Australia business, whose headquarters is in Melbourne.

Aggressive bond issuance since then by governments in the U.S., Japan and Europe has caused rapid changes in those indexes and their risk parameters, effectively forcing investors to evaluate which of those changes they're happy with and which entail unwanted risks, he said.

With yields near historic lows and the accumulated indebtedness increasing among developed countries, traditional bond markets “have never been riskier,” and a lot of mental energy is going into figuring out how to continue having “sovereign global exposure without the excessive concentration,” said Andrew Canobi, a vice president, fixed-income portfolio management, with Deutsche Asset Management in Melbourne.

How to adjust passive allocations to account for those greater risks is a “red-hot conversation now,” said Mr. Horn, who called moves such as VicSuper's the “tip of the iceberg” in terms of changes being made by institutional investors.

Still, there is far more talk than action.

Alternatives to market cap-weighted bond indexes — designed to avoid the pitfall of having to make ever-greater allocations to countries falling further and further in debt — have yet to gain traction in the region, investment consultants say.

Such alternative “smart beta” benchmarks include the GDP-weighted Global Advantage Bond index launched by Pacific Investment Management Co. in 2009 and the RAFI sovereign bond index launched by Research Affiliates LLC in 2012, which uses a combination of GDP, population, landmass and energy consumption to determine a country's sovereign bond weighting.

Garnered clients

Investment consultants say PIMCO's offering has garnered a number of institutional clients in the Asia-Pacific region, even as consultants differ on the relative merits of GDP-weighted allocations. They declined to name the clients.

Peter Ryan-Kane is the Hong Kong-based head of portfolio advisory for Asia, ex-Japan and Australia with investment consulting giant Towers Watson & Co. He said that during the past six months, a handful of his firm's institutional clients in the region have moved to cap exposure to U.S. and Japanese sovereign bonds at levels well below what a market-cap-weighted index would call for.

That's a fraction of the pool of clients holding discussions with Towers Watson about their bond allocations. Still, Mr. Ryan-Kane predicted a growing number would eventually opt to move away from market-cap-weighted indexes, even if the good outcomes enjoyed by those who have stuck with a traditional approach to bond allocations in recent years have left many confident that they don't have to rush.

The topic of bond benchmarks is less pressing for institutional investors with actively managed allocations.

Ken Marshman, chairman and head of investment outcomes with investment consultant JANA Investment Advisors in Sydney, said VicSuper's custom passive bond benchmark appears innovative. He added, however, that the bigger story now is the degree to which investors with actively managed bond allocations have been deviating from their market-cap-weighted benchmarks — adopting either a broad, combined target for cash and bonds or “wide open,” go-anywhere mandates.

Still, many of the region's institutional investors oversee too much money to rely primarily on active management.

Among them, central banks looking to manage their foreign exchange reserves are aware of the potential risks they face keeping their fixed income-heavy portfolios benchmarked to market-cap weighted indexes, and are studying alternatives now, noted Jason Hsu, chief investment officer with Research Affiliates, Newport Beach, Calif.

In Australia, meanwhile, government regulations calling for superannuation fund providers to introduce more low-cost options for participants by July could further bolster the focus on new approaches to relatively inexpensive passive bond allocations.


Mr. Walsh, in his e-mail, said VicSuper's new benchmark leaves the 40% credit component of the Barclays Global Aggregate unchanged, while the sovereign component “applies a 10% individual country cap and a 30% collective cap on Eurozone countries.”

The customized index is then “overlaid with the BlackRock (BLK) Sovereign Risk index,” which goes beyond standard metrics and adds factors that can affect credit quality, including willingness to pay and political risk, in evaluating sovereign bonds, he said.

On its website, VicSuper said it worked with Towers Watson, BlackRock Investment Management and index provider Barclays Capital to construct the new benchmark.

BlackRock, which managed VicSuper's previous market-cap-weighted core international fixed-income allocation, will manage the customized passive benchmark as well.

According to VicSuper's latest annual report, participants had A$547 million, or roughly 6% of VicSuper's portfolio, invested in a market-cap-weighted BlackRock Global Fixed Interest strategy as of the June 30 close of the fund's latest fiscal year. At present, that total is closer to A$580 million.

This article originally appeared in the January 21, 2013 print issue as, "VicSuper's new index takes knife to U.S., Japan bond exposures".