Title: Author: Overcoming the Limitations in Traditional Fixed Income Benchmarks Clive Smith Portfolio Manager Date: October 2011 Synopsis: The last decade has seen material shifts in the composition of issuance in fixed income markets as countries have gone from booming economies with lower levels of government borrowing, to recession with governments having to effectively internalise a proportion of private sector debt. Such compositional shifts have highlighted the deficiencies in traditional fixed income indices. An important implication of these compositional shifts over time is that investors can no longer take for granted that traditional benchmarks accurately represent their desired risk/return profile for fixed income portfolios. The aim of this paper is to discuss these deficiencies and to propose one potential alternative approach for investors when considering benchmarking fixed income portfolios
OCTOBER 2011 Overcoming the Limitations in Traditional Fixed Income Benchmarks By: Clive Smith, Portfolio Manager INTRODUCTION The last decade has seen material shifts in the composition of issuance in fixed income markets as countries have gone from booming economies with lower levels of government borrowing, to recession with governments having to effectively internalise a proportion of private sector debt. Such compositional shifts have highlighted the deficiencies in traditional fixed income indices. An important implication of these compositional shifts over time is that investors can no longer take for granted that traditional benchmarks accurately represent their desired risk/return profile for fixed income portfolios. The aim of this paper is to discuss these deficiencies and to propose one potential alternative approach for investors when considering benchmarking fixed income portfolios. EQUITY VERSUS FIXED INCOME BENCHMARKS The central issue facing investors with respect to selecting fixed income benchmarks is the complexity of fixed income markets and the resulting implications for the construction of the associated benchmarks. This is especially true when compared to equity markets, where the underlying securities are quite vanilla; i.e. the nature of the issuer will vary but not the nature of the actual security. Further, there is a central clearing exchange which provides pricing transparency and eases identification of the relevant companies to include in the equity benchmark. Given this, equity benchmarks are often appropriate indicators of the investible universe. Fixed income markets in contrast exhibit increased complexity given: the number of securities in the universe; the diversity of issuers and types of securities ranging from vanilla government bonds to non investment grade corporate debt, which may in turn be convertible into equity; high turnover of securities as securities pass in (new issuance) and out (mature or bought back) of the market; lack of central exchanges, being OTC (over the counter) securities, to provide clear pricing; existence of highly developed derivatives markets; and globalised nature of fixed income markets, which makes distinguishing based on regional criteria more difficult. 1
Due to these factors, traditional fixed income benchmarks need to establish specific criteria for determining which fixed income securities will be included in a benchmark and how the weightings will be established. The establishment of such selection criteria also means that there tends to be a wider range of potentially usable fixed income benchmarks. Differentiating between each potential benchmark is complicated, as each is trying to capture a different part of the fixed income market rather than capturing what may be termed the entire fixed income market. It is for this reason that the overall risk characteristics of a potential fixed income benchmark becomes more relevant to an investor than the exact nature of the individual securities included in the index. As traditional fixed income benchmarks are constructed on the basis of outstanding issuance 1, the resulting risk characteristics of the benchmark are therefore driven by the actions of market participants, i.e. the issuers, with the benchmark tending to tilt over time towards the issuance profile of the largest creditors. This focus on issuance outstanding not only results in changes to the risk characteristics of a benchmark over time as issuance patterns change/evolve, but also tilts the benchmark exposures towards the largest borrowers. As a result of such characteristics traditional benchmarks are widely accepted as being inefficient; i.e. not representing the best risk return profile to investors. On the one hand, this provides opportunities for investors to construct benchmark relative portfolios which provide superior risk return characteristics to a fixed income benchmark. On the other hand, it creates a dilemma as the general risk characteristics of a benchmark may not coincide with an investor s desired risk characteristics, and even if they do there is no certainty that it will continue to do so over time. This has important implications for investors as the definition of the appropriate benchmark is essential in order to not only interpret the level of return enhancement from an actively managed portfolio, but even to make interpretation of return enhancement relevant. Put another way, there is no point in constructing a more efficient portfolio relative to the wrong benchmark. KNOW THE BENCHMARK This makes it important for investors in fixed income markets to understand and know the benchmark. Or more appropriately, investors need to ensure they select a fixed income benchmark which represents their desired risk characteristics over a full cycle. This in turn requires that they must understand and define their desired risk characteristics or beta. Such risk characteristics could include specifying criteria according to measures such as: Interest rate duration Credit spread duration Average or minimum credit quality; i.e. level of desired default risk. Total volatility Desired diversification characteristics both within fixed income and between fixed income and other asset classes Other requirements such as income needs, prohibited securities etc. Once this has been done, one approach is for the investor to then look for an appropriate traditional benchmark which best approximates the desired range of risk characteristics. Having done this, assuming that an investor is constructing an actively managed portfolio, the next step is for the investor to identify where inefficiencies may exist in the benchmark and where appropriate, relax such constraints in the construction of their portfolios so as to achieve a more desirable/efficient risk/return outcome. In the process of relaxing constraints, the investor then sets tolerances around the key risk measures, the cumulative impact of which may be summarised by a measure such as tracking error 2. 1 2 In the context of this paper the concept of a traditional fixed income benchmark refers more broadly to any benchmark which either explicitly or implicitly utilises the level of issuance outstanding when determining the weighting of a particular issue within all or part of the index. Accordingly GDP weighted benchmarks which utilise liquidity inputs/overlays are also included in the scope of traditional fixed income benchmarks. For a passively managed portfolio, the risk tolerances are simply much narrower. 2
The central issue with this approach to constructing the benchmark is that it does not avoid the potential risk that over time the characteristics of the benchmark may change or drift over time, thereby moving the benchmark away from the investors desired risk/return characteristics. For many investors, the potential for such a drift in the beta characteristics of the benchmark may be viewed as quite acceptable. If this is the case then investors may respond by building greater degrees of freedom into their portfolios, so as to reduce the need to continually rebalance back towards the benchmark. This will work up to a point but there is the potential that the divergence in desired benchmark characteristics becomes so great that the benchmark s very relevance becomes problematic. In response to this issue it may be tempting for investors to simply put everything in the too hard basket and just say that fixed income will be managed in a benchmark unaware manner with a focus on a total return objective. But what does this style of investing entail in practice? Normally it refers to providing managers with a wide range of allowable investment strategies which aim to incorporate a broad range of fixed income securities. Further, such mandates are normally stated as floating rate ( LIBOR ) based returns or define as an absolute return target. On the one hand, such strategies free the investor from the compositional issues associated with traditional benchmarks. However it does not negate the need for the investor to define their desired risk characteristics when determining what types of strategies to include. Hence even though such a formal benchmark is not required within the construction of a benchmark unaware portfolio, the investor still needs a means of quantifying the risks assumed and the desired return for assumption of such risks. In other words, the removal of a formal benchmark does not remove the need for the investor to establish acceptable risk tolerances and return requirements. This leads us to the logical extension for investors to take the idea of benchmark unaware investing one stage further in order to solve some of the problems already highlighted. As the earlier discussion highlighted, the first step in selecting an appropriate benchmark is for the investor to define their desired risk characteristics. Once the investors have defined these risk/return characteristics there is no logical rationale as to why a traditional broad market benchmark is required in order to act as a summary of these characteristics. Effectively the investor simply cuts out the middle man and defines allowable risk limits of the active portfolio directly in terms of the specified risk characteristics. The key point is that the investor no longer needs the benchmark in order to define risk and hence the risk measures now become more stable. The investor in the fixed income space can now break away from thinking in terms of traditional benchmarks, and instead focus more on identifying the desired outcome from their fixed income portfolio; i.e. desired risk/return tradeoff. CUSTOMISING THE BENCHMARK Does this mean that benchmarks have no use? No, it does not. A benchmark of some sort is still required as there is a need for investors to be able to quantify the success of their active strategy. However, the use of a traditional broad market benchmark may not be efficient as its characteristics may not reflect appropriate risk/return characteristics, and/or may be changing over time. What is required is a way of constructing a benchmark where the characteristics have been, as far as is practical, established and stabilised. What this may entail is identification of a particular set of beta exposures which can then be quantified and represented by sub benchmarks. The sub benchmarks can then be combined to create an appropriate (or stabilised) overall benchmark ( risk/return profile ). These sub benchmarks may be termed as beta benchmarks as their purpose is not to represent an investible universe, but rather to simply represent particular fixed income beta characteristics. The benefit of such an approach is that the composition of the aggregated benchmark can now be adjusted over time by the investor to ensure that it remains consistent with the desired risk/return pattern. What impact does this benchmark have on the management of the active portfolio? None what so ever! The active portfolio is managed with respect to the investment guidelines which are specified in terms of the outright risk characteristics previously specified by the investor. The beta benchmark is simply utilised as a means of quantifying the returns associated with the particular beta exposures assumed so the investor can appraise performance. In this sense, the security specific composition of the beta sub benchmark is of secondary importance, and indeed is largely irrelevant, to the specific beta exposure they are trying to capture. 3
A simplified example is shown below. In this example, the sub portfolios for the beta benchmark approach are simply categorised into Very Short Term Credit and Long Term Risk Free. These two beta benchmarks encompass the two extremes of the trade-off between credit and interest rate risk. As Chart 1 highlights, the utilisation of these two portfolios allows the investor to create any risk combination along the solid line. As a starting point, assume that a broad market benchmark (Benchmark t) captures the client s desired risk reward profile at Point A. The client has two ways of benchmarking performance. Either they can simply use Benchmark t or combine the two beta benchmarks in proportions which replicate the desired risk characteristics at Point A. Initially, all else being equal, the investor should be indifferent between the two approaches to benchmarking. CHART 1: SIMPLIFIED EXAMPLE The benefits of using the beta portfolio approach to benchmark construction are highlighted in the situation where the risk/reward characteristics of the broad market benchmark drift over time due to reasons we discussed earlier. This is represented by the situation where the risk/reward characteristics drift to the lower right to Benchmark t+1 (Point B). In this situation, the risk/reward characteristics of the broad market benchmark are no longer representative of the investor s desired risk/reward profile which remains at Point A. For a client who is limited to the utilisation of the broad market benchmark, they have no choice but to accept this drift in risk/reward characteristics, thereby moving them to a sub optimal point; i.e. Point B. However if using the sub portfolio approach to benchmark construction, the investor can effectively compensate for the drift by altering the allocation between the two sub portfolios in order to remain at point A. By allowing for the modification of allocations between sub portfolios, the beta exposure approach to benchmark construction provides greater flexibility with respect to tailoring benchmarks to their desired risk/reward profiles. 4
CONCLUSION This paper has highlighted some of the issues associated with traditional fixed income benchmarks. For some fixed income investors, the use of a standard broad market benchmark as the basis for constructing fixed income portfolios, either active or passive in nature, may provide adequate approximations of their desired risk return characteristics. However, for many investors, the use of broad market benchmarks will not approximate their desired risk return characteristics. Given the approach taken to constructing most traditional style benchmarks, investors must be careful therefore, to not take for granted that the benchmark reflects their risk/return characteristics, nor will it necessarily continue to do so over time. As a result, clients may want to look at more explicitly constructing fixed income portfolios to achieve specific risk/return outcomes. In turn, this requires the delinking of the benchmark, for evaluation of performance, from the establishment of investment objectives. In such an approach, the benchmark simply becomes a proxy for the range of beta exposures which the investor believes represents their desired risk/return profile. Disclaimer This document is issued by Russell Investment Management Pty Ltd ABN53 068 338 974, AFS Licence 247185 (RIM). It provides general information for wholesale investors only and has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Past performance is not a reliable indicator of future performance. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Copyright 2011 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from RIM. First used: October 2011 R_RPT_RES_FILimitation_V1F_1105 MKT/4172/1011 5
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