Alternatives to cap weighting boost diversification — especially to emerging markets — and deliver better returns, money managers say.
Fundamentally weighted indexes use factors such as debt-to-GDP ratios as indicators of a country's creditworthiness. Long used in equities, such alternatives to market-capitalization-weighted indexes and benchmarks are fairly new to bonds.
Using cap-weighted bond strategies puts most of the assets in the hands of the most-indebted issuers. For global government bond indexes, that means concentration in the bonds of debt-laden and growth-strained countries such as the U.S., Japan and Italy.
“It's hardly the best place to invest your pension money,” said Stephane Monier, Geneva-based chief investment officer for fixed income and currencies at boutique Lombard Odier Investment Managers. He added that when downgraded issuers fall off a cap-weighted index, “you have a lot of selling pressure, which ... detracts from your performance.” Lombard Odier runs about e10 billion ($14.4 billion) in fixed income — about e2 billion of which is in its new fundamentally weighted strategies — for institutional clients, primarily in Switzerland and the Netherlands.
BlackRock Inc., Pacific Investment Management Co. LLC and State Street Global Advisors have developed or are working on alternatives to non-cap-weighted approaches, while Barclays Capital, Research Affiliates LLC and TOBAM have developed or are working on non-cap-weighted indexes.
While the arguments against cap weighting in bonds are well known, an obvious replacement hasn't emerged, experts said. “It's something we are looking at,” but the search is “a work in progress,” said Martyn Simpson, senior associate in Mercer LLC's bond manager research boutique in London. “We haven't come up with a one-size-fits-all solution for our clients.”
Non-cap-weighted approaches introduced so far are fine in theory, but “there are quite significant practical limitations to a lot of them,” said Roz Amos, senior investment consultant at Towers Watson & Co. in London.
Felix Goltz, head of applied research at the EDHEC-Risk Institute, Nice, France, said non-cap-weighted bond indexes do reduce the problem of investing in the most-indebted countries (or companies, in the case of a corporate bond strategy), but “in terms of controlling risk exposures, they don't achieve much.”
One of the biggest complaints about non-cap-weighted approaches is liquidity. For example, the sovereign debt of countries such as Norway and Sweden are considered very high quality, but the number of bonds available for investment “simply do not exist,” said Benjamin Brodsky, London-based managing director and global head of fixed-income asset allocation and emerging markets in BlackRock's quantitative bond group.