Bond Compass

The Index Turning Point

Institutional investors appear to be at a turning point with the construction of fixed income portfolios. According to recent institutional investor research conducted by State Street Global Advisors of more than 350 global respondents,1 66 percent said increased use of indexing is a high priority for liquid, core fixed income exposures. Further, 63 percent gave high priority to indexing for less liquid, non-core fixed income exposures over the next three years and 68 percent indicated that exchange traded funds (ETFs) will play a bigger role in their fixed income portfolios.2


Indexing appeals to fixed income investors for many of the same reasons it appeals to equity investors — indexing delivers cost-effective, diversified, and liquid exposures. And today’s ultra-low rate and spread environment, where fees have a larger impact on yields and returns, makes indexing’s cost-effectiveness more attractive than ever.

And with investors relying on indexed fixed income to achieve a broad range of goals, from maximizing the impact of asset allocation decisions to complementing active strategies and accessing less liquid segments of the fixed income market, use will continue to accelerate.

How does fixed income indexing work?

Index tracking can be done through a full replication methodology that holds all of the underlying securities in the index in the respective weights or by employing a sampling strategy. Sampling can be the most efficient technique for constructing portfolios as many broad fixed income indices include a large number of securities, but not all of those securities can be purchased. Couple this with potentially high transaction costs to access illiquid bonds and full replication isn’t always possible or practical.

Asset managers such as State Street Global Advisors (SSGA) use a sampling approach when indexing fixed income and managing ETFs. Rather than owning every security in an index, the goal is to build portfolios with the same characteristics as the index.

For example, SSGA takes both a top-down and bottom-up approach to limit exposure differences while maximizing the benefits of sampling to ensure that the index’s performance and characteristics are replicated.
A top-down approach seeks to align the key risk dimensions of the fixed income strategy to the index, including:

  • Duration: Matching on key rate duration exposures across the curve
  • Sector exposures: Aligning sector and industry compositions to manage macro impacts
  • Quality: Selecting to ensure good alignment along the credit rating dimension
  • Credit spread: Examining differences between option-adjusted spread as well as other metrics such as option-adjusted spread duration at the issue and issuer level.

These factors are typically the key variables that drive market beta.

A bottom-up security selection approach is often used in markets such as high yield, emerging markets or convertible bonds that typically can have high idiosyncratic or security specific risk, coupled with higher price volatility. In a bottom-up approach, SSGA seeks to identify large or outsize idiosyncratic risks and ideally neutralize or certainly mitigate them. For example, we might decide to purchase one bond versus another from a company based on its position in the credit curve. Cost per exposure (similar to a bid-ask spread or transaction cost) is another key input when evaluating sampling and prioritizing various betas.

Indexing in less-transparent markets

Through market structure changes and new portfolio management techniques, an experienced index manager can continue to push the boundaries of what is possible in indexing. Everything from emerging market debt (EMD) and high yield (HY) to convertibles is an exposure that can now be delivered reliably and efficiently via index strategies.

In the past, the high cost of replication, market volatility and inefficiency were the main obstacles to the use of index strategies in these less transparent fixed income markets. Although these concerns were once valid, improvements in price discovery and trading and indexing techniques mean that implementation has moved a long way from index replication. Today, experienced investment managers can minimize and offset these negative effects.

In fact, the cost of indexing in these less transparent markets is no longer prohibitively expensive. The trading cost for EMD hard currency bonds is now comparable to investment-grade corporate bonds, and the cost for local currency-denominated securities is a fraction of that.3

For both HY and EMD, indexers can keep costs low by employing portfolio management techniques such as minimizing turnover — and value can also be added by exploiting market inefficiencies, gaining exposure through the primary markets while also proactively anticipating index changes. Specific to emerging markets, indexers can also control all FX trades (even in controlled currencies) and manage exposure effectively through the forward or nondeliverable forward markets to ultimately deliver benchmark returns through a thoughtful but tightly risk-controlled investment process. This reliable and efficient delivery of EMD returns contrasts with the variability and higher costs associated with active managers in EMD.

Indexing alongside active management

As the sources of alpha have become increasingly better understood, investors are questioning whether they should be paying active fees for what may simply be asset allocation decisions, such as structural overweighting of credit to outperform their benchmarks. Moreover, the bond market dislocation in March 2020 may have prompted some investors to question the wisdom of relying solely on an active manager.

The findings from SSGA’s research on institutional investors’ preferences and intentions show that investors whose fixed income portfolios are predominantly allocated to active strategies were less satisfied with performance across various fixed income sectors over the last three years than those that had a higher share of indexing.

Conversely, investors that complement their alpha-seeking active managers with indexing strategies may be achieving better outcomes in the form of lower costs and, importantly, the ability to maximize the impact of their asset allocation decisions. For institutional investors with more balanced indexed/active fixed income portfolios, the percentage of those that were somewhat satisfied/extremely satisfied with active managers’ performance was materially higher than those with heavily active and mostly active portfolios.4

Because index strategies can complement active strategies and provide investors with greater flexibility to tactically allocate and fine-tune exposures to target allocations, more investors now employ both active and index approaches to their overall fixed income program.

SSGA fixed income indexing capabilities

With indexing set to play a bigger role in fixed income allocations, these four steps can help you analyze your current fixed income approach and determine whether it can be improved:

  1. Evaluate: What are the costs and complexities of your current approach?
  2. Determine: Are your objectives being met consistently and efficiently?
  3. Analyze: If employing multiple managers, are there offsets to their styles? Does that impact the overall outcome?
  4. Act: Should you replace the weaker manager(s) with an index strategy to reduce costs, improve performance reliability or facilitate tactical allocations?

In many instances, a switch to indexing can bring greater cost-effectiveness and performance transparency as well as diversification and liquidity benefits.

Choosing an experienced index manager is also key. Founded in the late 1990s, SSGA’s Global Fixed Income Beta Solutions team has accumulated significant knowledge and insight through multiple market cycles, crises and conditions. The strength of our indexing process and risk management has been tested during bouts of volatility, not only during calm markets. And today our mission remains to deliver reliable, transparent and risk-controlled exposure to our clients’ benchmarks as precisely and cost-effectively as possible.

Authors

William Ahmuty
Head of SPDR Fixed Income Group

Matthew Bartolini, CFA
Head of SPDR Americas Research

Patrick Bresnehan
Head of Fixed Income Beta Solutions

David Furey
Head of Fixed Income Strategists, EMEA