Wellian Weekly 12.04.2021

Is Passive Investing Suitable for Fixed Income Investing?

Before anybody has a go at me suggesting I’m all for active investing and anti-passive, this is not the case. Passive investing has done wonders for the financial planning and the investing profession. It has helped force prices lower; it has introduced lots of people to the benefits of investing. It has simplified investment understanding. Investors in passive funds should see their returns closely aligned to the returns of the index the passive fund is replicating because there is no need to explain why or how the active fund out- or underperformed.

In reality, all you need to know as an investor in passive funds is the answer to the following two questions:

  • What index are you replicating?
  • What is the investment approach undertaken by the passive manager?

Although I said earlier that passive investing has forced prices lower, I can’t see a price war really forcing investment decisions. Most passive index funds are below 10bp these days and the “cost” associated with selling a passive fund at 10bp to buy one at 8bp might not actually be worth it.  Even if a fund went from 5bp to 0bp, the cost per £10,000 invested per annum is not really a big number.

But, please remember not all indices are calculated in the same manner and even if two funds are both “replicating” the same index, they could actually have very different outcomes in terms of returns.  Not all passive funds are fully replicating – many employ sampling techniques to get their investment style as close to the index as possible. Others will not use physical instruments at all, preferring to use derivatives instead. On top of that, the use of stock lending, the cost of managing the fund and tracking error tolerances can mean there is a great deal of due diligence needed when it comes to selecting which fund(s) are going to the be home for capital allocation for the fund selector or financial adviser.

There are a number of major index manufacturers and a multitude of minor index manufacturers and even more customised index makers too (this article is not going to go into whether smartbeta is passive or active – lots can be written and justified for both arguments) and not all indices are calculated in the same manner either which can add extra complexity to the due diligence process. Some indices cannot be replicated at all through full replication (property, commodity for instance) and unless the underlying components of the index are liquid and have relatively tight spreads there can be further complications.  Therefore, building a fully diversified portfolio only using index funds could be compromised. This article is to ask whether passive and fixed income make for good bedfellows.

I recently undertook a research project looking at the Bloomberg Barclays Global Aggregate Bond Index. The index “is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.” To understand further how the index is created and calculated, feel free to read the index calculation methodology here

Looking at the fact sheet of the State Street SDPR Bloomberg Barclays Global Aggregate Bond ETF, the following questions sprung to mind:

    • According to the fact sheet, the index has c21,380 components, whereas the Exchange Traded Fund has 5,704. Obviously, this is not a fully replicating index!
    • The ten largest investments account for a little over 3.50% of the index
    • The ETF is managing over $1.84bn in this strategy. This is certainly large enough to be considered “efficient” from a cost perspective, and arguably the passive index could contain more stocks
    • At 0.10% TER, this should be considered very attractive from a cost angle

Fact sheets are a snapshot in time, and looking in isolation at one fact sheet the following haven’t been explained:

  • Less than 18 months ago, the ETF had 2,571 underlying instruments, whereas the index still had c21,380.
  • The top 10 – 18 months ago accounted for 3.28% of the assets (a number very similar to the latest fact sheet). But, since the summer of 2019, there has been over 60 instruments in the top 10.  As you know, unlike equities which are “perpetual” in terms of life, fixed income assets have a maturity date.  Fixed income instruments can call their debt forward. If interest rates fall for instance, companies and countries can potentially refinance at cheaper rates which could mean significant changes to the constituents.
  • Keeping on top of fixed income indices and their make-up is arguably more demanding compared to equity indices.
  • The characteristics of equity markets are different to fixed income. For instance, a company that has a high market capitalisation has a higher allocation in the index. In fixed income terms, the country / company that has higher amount of debt has a higher allocation in the index. Do you really want to own more of the debt of a company / country because it, in itself has lots of debt?
  • The “duration” of the fixed income index is constantly changing. If new debt is issued, or existing debt matures, the maturity profile of the index changes and this can add or remove risks, as can the quality of the issuer. For example, at the end of July 2020, 1.36% of the portfolio was due to mature within 12 months. As at the end of January   this had fallen to 0.71% - this in essence increases risks as there is more money tied up in the portfolio.
  • Over the last 18 months for instance, the quantity of AAA issuers has fallen from 39.70% to 36.46% and the A rated issuers has risen to 32.36% (from 30.32%).
  • Taking the final two bullet points together has the index becoming riskier – the credit quality has fallen and the time to maturity increased whilst the investor is not being rewarded. 18 months ago, the yield to maturity was 1.17% and today it is 0.87%, so for these increased risks, the reward (yield) isn’t there for the investor.

This piece is not to suggest whether the index is a good one or a bad one to follow, but more to raise questions and concerns surrounding the fact the index has over 20,000 component parts and the ability to be able to fully replicate the index being very hard to do with such a low cost.  When a fund management company adopts sampling techniques, then tracking errors and tracking tolerances need to be considered. The credit quality of the counterparty/ies needs to be taken into account too – after all, by using derivatives an extra degree of risk is added into the mix.

I would argue that one of the reasons why this index is not fully replicated is liquidity / lack thereof.  Fixed income instruments are traded over the counter, rather than via an exchange and there are many more debt instruments in the marketplace compared to equities. Also, in fixed income investing you cannot buy an amount of an issue that makes the fractional quality work. Most fixed income deals are done in nominal amounts, so as the number of assets in the index rises, the complexity rises too when it comes to replicating the index.  There is a very big difference between theory, practice and reality.

In a conversation with a fixed income fund manager the other day, it was highlighted that many large and mega-cap companies have just one listing of their equity but might well have 50 or more debt instruments available (when you take into account currency offerings, coupons, maturities, credit quality and so on) for the fixed income manager to ponder. It might be put forward that this fact shouldn’t be an issue for the index – after all, if it is an index constituent then it should be replicated in the index and therefore, ultimately, the ETF. But, some of the debt instruments on offer might not have a secondary market, might be of an issue size that makes it inefficient for a passive fund to get a meaningful quantity in the first place.  As previously mentioned, the top 10 account for less than 4% of the total suggesting over 21,300 bond issues account for 96% of the index.

Fixed income markets are much larger in terms of total assets compared to equity markets, but with the issues highlighted above, there are many more nuances that make full replication of these indices much harder than equity markets.

As previously mentioned, unless you have done your due diligence on the instrument you are looking to replicate and understand its foibles and constraints, investing passively is just as complicated as investing actively and in many circumstances much more complicated. When an index has tens of thousands of components and a fixed life, would full replication not be achievable at such a low cost?  Therefore, are you investing passively due to cost, or due to replication?  When the FTSE 100 has 100 stocks, and 500 stocks constitute the S&P 500, and both indices are large and liquid full replication is not a problem.  Can the same be said for an index such as the Bloomberg Barclays Global Aggregate Index which has so many instruments?



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