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 Inc. 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.