The traditional distinction between developed and emerging markets has gradually blurred over the past 15 years – recent volatility notwithstanding – as emerging economies tamed inflation and developed markets faced the financial crisis, rising debt burdens and political polarisation.
Yet, old habits die hard: the indices that track these economic dynamics haven’t moved with the times and still impose weightings based on these outdated distinctions. Ramin Toloui, Pimco’s co-head of emerging markets, summarised it nicely when he said that the “mental and organisational infrastructure in the asset management industry has been built for a world with a sharp dichotomy between developed countries and emerging markets”.
It’s worth noting that while some investors might interpret the volatility of recent months in emerging markets as evidence of a clear distinction, PIMCO takes a long-term view: we believe that the unprecedented intervention by global central banks in markets that we’ve seen in recent years will gradually subside, and that global markets will, once again, be driven by fundamentals rather than technical factors such as a reaction to Fed tapering.
Pimco decided that these outdated dichotomies were doing a disservice to investors by essentially measuring a country’s contribution to an index by the debt it issued, rather than the growth it produced. Think of it as telling an investor to lend to those who need to borrow, rather than those who can afford to repay.
The failings of market-cap weighting are twofold – notional and pricing. The notional problem, or what we call lending to the leveraging, might not be problematic for equity investors, but bond investors automatically increase their exposure to entities that have a growing outstanding notional value of debt. More debt nearly always means higher leverage and greater financial vulnerability. For corporate borrowers, financial vulnerability can mean more debt defaults, and less money recovered when they do default. For sovereign borrowers, financial vulnerability is more likely to result in greater inflation premiums and other, subtler forms of haircuts on bondholders, including maturity extension.
The second problem, pricing, is the buy high, sell low impulse. Affecting both equity and bond investors alike, this adds a momentum bias to capital allocation, rather than a value approach, forcing investors to chase yesterday’s capital gains in the hope that they continue. The problem in the bond market, of course, is that as prices rise, yields fall, making capital gains less likely.
The Japanese government is perhaps the highest profile issuer that demonstrates both of these index flaws to the extreme. Fiscal authorities in Japan have tried to prop up growth and inflation via deficit spending for over two decades, leaving the economy saddled with the highest debt burden in the world.
• Traditional indices lend more to the leveraging.
• They also force investors to buy-high and sell-low.
• GDP-weighting rewards ability to pay and re-introduces counter-cyclicality be lost in a smart-beta product.
It hasn’t worked. Yields have declined, reaching just 0.7% today on the 10-year issue. Capital gains were extraordinary in the early 1990s when yields were first declining and index weights were first increasing, but no longer. Exposure to Japan in a market-capitalisation global government bond index is more than twice as high as it was 20 years ago. This isn’t what a global investor wants at a time of aggressive reflationary policy designed to shock inflation higher, which, if successful, will ultimately impose capital losses on bondholders.
We can see the same dynamic beyond sovereigns – for example, banks as they levered their balance sheets in the years leading up to the financial crisis. In other words, whether it’s at the sovereign or corporate level, a market cap-weighted index will simply reflect whatever bubble is present in that country or sector.
If investors are not to base their capital allocation decisions on market-capitalisation, then how should they? The answer lies in the classic banker’s adage: lend to those who don’t need to borrow. Pimco adopted the opposing measure to debt – income – in designing its bond indices.
“If investors are not to base their capital allocation decisions on market-capitalisation, then how should they? The answer lies in the classic banker’s adage: lend to those who don’t need to borrow. GDP-weighting turns the capital allocation decision on its head, switching from degree of indebtedness to ability to pay”
GDP-weighting turns the capital allocation decision on its head, switching from degree of indebtedness to ability to pay. And since yields tend to rise during the expansion phase of the business cycle when GDP growth picks up, GDP-weighting can help reclaim a buy-low, sell-high framework for the value investor. This GDP-weighted alternative has outperformed counterpart market-cap-weighted indices, such as the Barcap Global Aggregate index, by roughly 0.6% per year since the beginning of index data just over 10 years ago (Barclays launched its own GDP-weighted global bond indices in 2009, as well as ‘fiscal strength’ indices in 2011, and they are used as benchmarks by, among others, Norway’s Government Pension Fund Global. Other asset managers have developed similar fundamentally-weighted bond benchmarks for their pension fund clients).
So how does this GDP-weighted alternative work? There are several key differences from a market-cap-weighted index: GDP weighting bases country and region weights on national income. Sector weights are hard-coded to ensure greater diversification across underlying risk factors, and to liberate investors from automatically allocating to issuer types – governments, corporations or households – that are going deeper into debt.
Issue weights are based on a unique methodology that limits the concentration of individual issuers and enhances the liquidity and investment appeal of the overall index. Finally, we believe that it is more representative of emerging markets than any single dedicated emerging market index, because it gives investors exposure to the currencies of countries that don’t currently offer investable bond markets, such as China.
Michael Story is product manager, responsible for European and global products at Pimco