Moving from semi-passive to fully indexed
Philip Nash portrays the road ahead for European core debt
At a time when the plight of the euro makes front page news, it is good to be able to draw attention to some of the benefits that it has bestowed on Europe’s bond markets. Principal among these are the ability of euroland’s institutional investors to expand the breadth of their portfolios beyond national boundaries and seek higher yields in the spate of corporate issues spawned by the euro.
Historically, institutional investment in Europe has been an essentially domestic affair. Whether because of currency matching, local regulation or simply nationalistic bias, portfolios have largely eschewed international investment. For example, the Watson Wyatt Global Asset Study estimates that as recently as 1996 the foreign equity component of pension funds in Germany and France was only 2% and 5% respectively. Bond portfolios have been even more domestically focused, with international diversification generally being obtained through foreign equity markets.
Now, with the currency dimension of risk removed by the adoption of the euro, and bond markets converging, Euroland’s institutions should be increasingly indifferent as to whether they hold government debt issued by one or another of the Euro-zone states. However, convergence of markets implicitly means that the diversification benefits of investing in other euro countries have contracted. This, hand-in-hand with the low level of interest rates in the Euro-zone, has forced institutions to seek higher yield elsewhere.
The search for yield has led institutions to increase equity weightings and also venture beyond government-issued debt to the corporate sector. In response to demand, credit issuance has boomed. According to Dresdner Kleinwort Benson, corporate bond issuance in the Euro-zone quadrupled in 1999 to almost e150bn.
This enhanced asset diversification is to be welcomed, although the core of most institutions’ euro-denominated bond assets will probably continue to be invested in the government sector.
The rapid rise in indexation as a technique for equity investment raises the question as to its applicability to bonds. Is the Euro-zone fixed income market an efficient market, making it suitable for indexing, or is it made inefficient by the actions of governments and central bankers, whose actions are driven more by policy decisions than by risk and return considerations?
To help answer this, it is useful to look to the US, where there is a large, well-developed single-currency bond market and where passive management is well established.It may therefore a preview of trends to come in Europe. The figure (drawn from a PricewaterhouseCoopers study, ‘25 Years of Indexing’) shows that indexation has gripped the imagination of America’s equity investors. Bond indexing, on the other hand has attracted barely one-third of the level of assets that have poured into equity index strategies.
Why should this be so? Are active bond managers cleverer than their equity counterparts and better able to outperform benchmark indices? To find out more about the ability of active investors to outperform successfully in US bonds markets, we examined data from a survey of 125 active bond portfolios compiled by Frank Russell.
Looking at the period from January 1, 1990 to the end of September 1999, we found that on a simple return basis the performance of the average US bond manager in a universe of core portfolios attempting to outperform the Lehman Aggregate Index, was 115.2%. The Lehman Aggregate index returned only 108.7%, around 6.5% less. This equates to 63 basis points a year of added value before fees taking into account.
To try to understand where this excess return was being generated we examined portfolio structures. In mid-1998, prior to the Russian debt crisis, the average weight of high yield in the survey portfolios was 7%. However, for the five best performing managers in the five years up to June 1998, the average weight of high yield was 40%! When the bond market experienced significant volatility in the third quarter of 1998, the same top five managers managed an average return of only 1.3%, significantly behind the index return of 4.2%. The suggestion is that some investors were generating excess return primarily by exposing their portfolio to higher risk, rather than necessarily demonstrating better selection skills.
To gauge whether market timing skills have enabled managers to move to more defensive positions prior to bond market corrections, we looked at all the quarterly periods over the last decade when there has been a negative market return in the US. There are eight in total.
During the eight quarters the average manager’s performance, at –9.9%, is below the index’s –9.1%. Approximately 40 basis points a year is therefore lost in bear markets. A more detailed analysis of information ratios would shed light on the risk/return benefits of active management, but this is beyond the scope of this article. However, the evidence would suggest that active bond managers struggle to outperform indices in weak markets.
The case for active bond management may be not much more convincing than the case for active equity management, once costs are taken into consideration. Why then has bond indexing been slow to attract interest?
The effective level of passive investing is probably significantly greater than surveys such as the PriceWaterhouseCoopers study cited above suggest. Many institutions across Europe have accumulated large positions of domestic government or government-backed bonds as their stable core asset class. These holdings are often managed internally, rather than outsourced to fund managers, and have been held for long periods, usually for liability matching purposes. These sleeping positions arguably do not qualify as active holdings, yet at the same time they are not included in surveys of passively managed assets.
Although it was relatively easy in the past to manage a domestic portfolio in this semi-passive way, the sheer size of the Euro-zone bond market is likely to pose more of a challenge. The Salomon Smith Barney Euro-zone Government Bond Index, for example, contains almost 300 securities, a figure that rises to more than 900 when we include investment-grade securities. Even amongst the government sector, it will be hard for smaller internal investment teams in pension funds and insurance companies to cope with the breadth of the market.
The euro, either directly or indirectly, has encouraged institutional investors to venture beyond domestic investment. We believe that at a time when euro interest rates are low and market convergence high, the scope for adding value through active bond management is not great.
Evidence from developments in US bond markets suggest that even by taking on more risk relative to the benchmark, active investors have not been able to produce returns that significantly exceed the active management hurdle - index return plus active fees and costs. In the years ahead, we expect the core euro government segment of portfolios to move toward external, index fund management, with investors choosing to spend their active risk on higher yielding and potentially less efficient segments of the Euro-zone bond market. Performance targets for these active portfolios could be higher, with correspondingly greater scope given for meaningful bets to be taken relative to benchmark. Now doesn’t that environment sound much more interesting?
Philip Nash is director of European institutional business at Barclays Global Investors