Implementation Alpha: Adding Value in Indexed Fixed Income

Index investing in fixed income markets is different than in equity markets. By their nature, bond markets are more fragmented and not as well structured as their equity market counterparts, resulting in them being relatively less efficient. For fixed income index managers with the skillset and experience to navigate through such challenges, there are ample opportunities to add value throughout the investment process. In fixed income markets, the same issuer can have multiple bonds, with each of them having their own characteristics (e.g. coupon, maturity, price). This gives rise to a very different market structure and liquidity profile than in equity markets. Furthermore, the decentralised OTC (over-the-counter) nature of fixed income market trading causes a variable liquidity profile to exist through time at the individual security level. This presents challenges and opportunities for fixed income investors — from both portfolio construction and exposure management perspectives — and these are as relevant to index managers as they are to active managers, despite their different objectives and constraints. When properly understood and controlled, these can be exploited very effectively by index managers to deliver highly reliable sources of incremental excess returns, or what we at State Street Global Advisors call our ‘implementation alpha’. For fixed income index strategies that seek to closely track the performance of the reference benchmark, both the approach taken on portfolio construction and the techniques employed within that are important. Essentially, the variable liquidity dynamics of the fixed income market make full index replication, in most exposures, either impossible or just so expensive that they essentially guarantee a performance shortfall over the long run. The question for index managers is how can they overcome these difficulties.