With many active bond managers failing to outperform their clients’ benchmarks over the last few years, indexing, or passively managing bond portfolios is becoming an increasingly popular alternative for plan sponsors. A passive strategy is defined as one that strives to match the return of the portfolio to a given benchmark. There are a number of reasons why plan sponsors may chose this management style for part or all of their fixed income portfolios.
First there are beliefs about market efficiency. If markets are efficient then it is impossible to outperform the market over the long run and a passive investment strategy is more optimal. The debate regarding market efficiency will doubtless continue as long as active and passive managers roam the planet, but most of us would agree that some parts of the capital markets are more efficient than others. For example, a plan sponsor may decide that government bond markets are more efficient than private equity markets and on that basis the plan sponsor may decide to manage their government bonds passively and spend their risk budget on the private equity portion of their portfolio.
Second, assuming we believe the market we are operating in is inefficient, do we believe we have the skill to exploit the inefficiency, or to hire a manager that can? Unsurprisingly, all active managers think they have this skill either because they have smarter people or a better process. However, from the plan sponsors’ perspective the choice of active manager is not an easy one. There is no guarantee the manager that performed well in the past will perform well in the future, or indeed, vice versa. Deciding to passively manage your bonds reduces the ‘manager risk’ of hiring an active manager since you are very likely to get a return close to the benchmark.
Third is cost. Fees for passively managed fixed income portfolios are significantly lower than for actively managed funds. The active manager must outperform by his fee level for the client just to break even on a net basis. While it is true that management fees will cause a slight drag on performance of passive funds, on a net basis this is typically much smaller and can be mitigated to some extent by a securities lending programme.
Managing an indexed bond portfolio
In order to meet the objective in passive management – minimising the return difference between the portfolio and benchmark – the passive manager needs to minimise the difference in risk between portfolio and benchmark, ie, the active risk. This requires a thorough understanding of the benchmark, how it changes and the assumptions inherent in its construction. The benchmark construction methodology, inclusion criteria, treatment of currency hedges, treatment of coupon flows etc, need to be established before portfolio construction can begin.
Since new bonds are constantly issued and old bonds mature, the constituents of fixed income indices typically change more frequently than their equity counterparts. In this regard, our firm works closely and proactively with benchmark providers to track index changes on a forward basis, so we are constantly and proactively prepared for changes in the benchmark.
Having thoroughly understood the nature of the index to be tracked the next part of the process is to construct a portfolio to do it. There are three main ways passive portfolios can be constructed: full replication, optimisation and stratified sampling.
Full replication relies on buying every security in the index according to its benchmark weight. Coupon flows should be reinvested in accordance with the index assumptions and the portfolio should economically reflect the index as closely as possible.
Unfortunately, it is not always possible or economically viable to fully replicate a benchmark. Some broader benchmarks contain thousands of different securities and some of these bonds may have been purchased and locked away by ‘buy and hold’ investors. In this case, although the bond is in the index it is impossible to buy it. Alternatively, even if a bond is available, less liquid securities may contribute significantly more to transaction costs, than the amount they reduce tracking error by.
To overcome these problems there are many occasions when an alternative to full replication must be used or is desirable. A simple way to do this is using a mean variance optimiser. A universe of securities that can be bought is optimised against the benchmark with the objective of minimising ex ante tracking error. The portfolio produced is the one that will have the smallest expected tracking error relative to the benchmark according to the risk model used. The significant drawback to this approach is that the risk models typically use historical volatility and correlation data to calculate the expected risk. Unfortunately, these are not always stable, particularly for corporate bonds where there is a high level of event risk.
A crude example of this would be a Worldcom bond. One year ago this bond may have been highly correlated with AT&T and the telecom sector. The risk model could therefore have indicated that either AT&T or the telecom sector could have been proxied with Worldcom, with only a small contribution to expected tracking error. In practice this would have had a disastrous impact on the passive portfolio’s performance relative to the index when Worldcom was downgraded and subsequently fell out of the index.
For this reason we have pioneered stratified sampling methods to match the benchmark’s defining characteristics in all volatility environments. We seek to match the returns of the benchmark by buying a well-diversified portfolio that represents a broad market index and matching multiple dimensions of risk or exposure. This approach recognises that no single measure of risk adequately captures all risk inherent in a portfolio. We therefore use a number of different measures to overcome this problem, such as partial durations by sector and quality, in addition to measures of issuer specific risk.
Enhanced management is a type of low risk active strategy that usually seeks to add 20-30 basis points of return relative to the benchmark. Many investors are drawn to this when they learn that the index they wish to track contains thousands of securities that cannot be obtained or bought. They then assume, perhaps incorrectly, that they will not be able to match the returns of the index and therefore opt for this low risk style of active management. While enhanced management can be attractive for many fixed income asset classes, and one in which we have considerable experience, drawing the conclusion from that enhanced is the answer based on the assumptions noted above can be dangerous.
First, any strategy, no matter how low risk, that seeks to outperform a benchmark must take active risk of some kind. There are no free lunches and on that basis it is still possible to under perform the index. To many investors enhanced seems to suggest that they are almost guaranteed the index return plus a bit more if they are lucky. The reality is that there is no certainty they will achieve the index return.
Second, if the index they wish to track contains thousands of illiquid securities it does not meet one of the main criteria of a good investment benchmark, namely it should be replicable and represent a realistic baseline strategy for a manager. Choosing an un-investable index and then assuming an active strategy is the only viable alternative is erroneous as the active manager is just as likely to fail as the passive manager, if all the securities in the benchmark are not available. We believe investors should chose an investment benchmark that is a realistic baseline strategy, and then make a decision on whether an enhanced strategy is appropriate according to their belief in the
efficiency and economic opportunity available in the market.
The future of bond management
We do not view active and passive bond management as opposing ideas but rather as complementary strategies. In the future it is probable that sophisticated institutional investors will want to combine both passive and active strategies in different fixed income asset classes to maximise the efficient use of their risk budgets. As such, we would expect to see a continued demand for well-constructed passive portfolios with minimal tracking error. Those managers who can provide customised and flexible investment solutions using passive, enhanced and active in a cost efficient manner are those most likely to be successful in the future.
Mark Talbot is head of international bonds at State Street Global Advisors in London