Institutional investors are starting to look to benchmarks and “better beta” indexes for something they used to get from government bonds: peace of mind.
As many of the largest sovereign bond markets have also become the most indebted, the use of cap-weighted investment approaches has made less and less sense, experts say, as cap weighting increases investments to a country as it becomes more and more in debt.
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.
BlackRock is developing a rules-based enhanced indexing approach for global government bonds that will overlay some fundamental selection criteria on existing cap-weighted indexes. The firm runs more than $10 billion in a similar corporate bond strategy.
“The scalability (of the sovereign strategy) would be very high, and the transaction costs also should be very low,” Mr. Brodsky said.
SSgA is working to expand its enhanced index alternative offerings, currently limited to a rules-based exchange-traded fund that screens corporate bonds using fundamental factors. “Certainly now what we're seeing with sovereign credit risk, we're looking to apply the same technology to other markets,” said Brian Kinney, managing director and global head of fixed-income beta solutions at SSgA, Boston.
In July, Barclays Capital launched its Fiscal Strength Weighted bond index family, also a rules-based fundamental approach, which adjusts market-cap country weights within existing Barclays Capital indexes based on public macroeconomic and governance data for each country.
“If you depend only on fundamental factor weights, you might not have an index that's (investible),” said Brian Upbin, director and head of benchmark index research at Barclays Capital in New York. The firm also offers other index alternatives, such as GDP-weighted and ones that cap exposures to single countries.
Research Affiliates plans an autumn launch for its new sovereign debt index. To ensure liquidity, the firm's process uses a “rescaling process” that shifts weights for smaller countries from those determined by fundamental factors closer to what they might be in an equally weighted portfolio, said Shane Shepherd, vice president and head of fixed-income research at the firm's Newport Beach, Calif., headquarters.
Company officials expect the sovereign debt index will top cap-weighted index performance by as much as 80 basis points annually.
In the eight months ended Aug. 4, Lombard Odier's strategy outperformed the J.P. Morgan Government Bond index-World by 1.47 percentage points, and at a lower volatility, according to data from the company.
PIMCO's Global Advantage Bond index, or GLADI, strategy, which invests in government and corporate bonds plus mortgage-backed securities and other instruments, has returned an annualized 12.55% since inception vs. 9.17% annualized for the Barclays Capital Global Aggregate bond index, PIMCO data showed.
Institutional assets in GLADI grew to about $5 billion since it was introduced in January 2009. Ramin Toloui, executive vice president and co-head of emerging markets portfolio management at PIMCO, Newport Beach, Calif., recognizes the GLADI strategy is capacity constrained, but said it can handle hundreds of billions of dollars. “It's not something the whole world can adopt overnight,” he said. “But the reality is, the whole world isn't switching overnight.”
Another major benefit to non-cap-weighted approaches is that they tend to incorporate more emerging markets debt into government bond portfolios, thereby increasing diversification and offering exposure to foreign currencies.
It is a way of “hard-wiring” emerg-ing markets exposure into a portfolio, Mr. Toloui said, pointing out that emerging markets are responsible for one-third of global GDP, more than half of global growth and that they are the world's creditors. For example, as of Sept. 30, China owned 9.5% of the U.S.'s total debt of $13.6 trillion, according to the blog Political Calculations.
“These factors are not being reflected in the current allocations of capital most investors have.”