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Our Approach to Leveraged Loan Indexing: A Q&A

The State Street Global Advisors Marketing team spoke with Matthew Coolidge, CFA, Fixed Income Portfolio Strategist, to discuss our process for leveraged loan indexing and to find out how we manage some of the most pressing challenges in indexing for this asset class.

Fixed Income Portfolio Strategist

1. Index investing across the broad leveraged loans asset class has been hindered. What are some of the difficulties with this type of investment style within this asset class?

While there are indexed loans products in the market, we believe that this is the first strategy that will provide a full, broad, representative beta of the universe. Operationally, loans are another animal from Treasuries, investment grade corporate bonds, or even high yield bonds. Loans are not securities, meaning there are different processes operationally, including a varied settlement process for asset owners. This burden makes it extremely difficult for a manager not completely dedicated to the business or to the asset class to take on the responsibility of managing assets.

The implementation of indexing in broad loans, while building on the growth and development in market structure of the loan universe over the last 10 years,1 is still difficult relative to other asset classes. Access to loans is more difficult than in more widely-traded asset classes such as high yield bonds. Transaction costs have certainly come down over time,2 but are still a major factor in sampling—the security selection process that chooses a representation of loans, rather than every loan in the index—and in being efficient in the sampling process.

As the asset class itself develops and gains popularity across varying investor types, we feel more attention and focus can only help. While the sampling process conceptually is not hard to understand, putting it to work in such a complex asset class, while minimizing tracking error and transaction costs and staying fully invested, is a job for a manager who is experienced in indexing across the fixed income market, and who has the resources to make it happen.

2. What differentiates State Street Global Advisors in the leveraged loan indexing space?

From an investment standpoint, we feel that the portfolio construction and trading aspects (e.g., the implementation) of stratified sampling in such a complex beta needs an experienced and capable manager. State Street Global Advisors is a market leader in fixed income indexing, with early capabilities in other difficult-to-index asset classes such as high yield and emerging market debt. This experience, along with developments in trading and market structure that State Street Global Advisors helped foster, have helped to lead the industry in sampling bonds across all fixed income asset classes. Specifically, while sampling may seem easy on paper, it requires skill and expertise to implement a repeatable, disciplined process that can consistently reduce tracking error, produce transparent beta, and occasionally add value from alternative security selection.

The actual implementation of sampling is anything but “passive,” and we have implemented the sampling process in one of the most opaque and nuanced asset classes- leveraged loans.

Within the sampling process, State Street Global Advisors uses primary markets to refresh its portfolios as much as possible, to avoid transaction costs where we can.

3. How does the construction and implementation process work, and how does State Street Global Advisors manage the difficulties we have discussed?

Our first priority in our leveraged loan indexing strategy is to deliver the desired index beta. No filler (non-loans allocations), minimal cash, and as low tracking error as possible. What we expect in terms of “low tracking error” in this asset class is certainly going to be different than that of an investment grade corporate bond index strategy (it will be higher). However, the sampling approach is the same across both strategies. Similar to how we have constructed our corporate bond portfolios for years—both investment grade and high yield—we will deconstruct the desired index into its most important, performance-driving risk characteristics. We will then populate the portfolio with loans, matching those risk characteristics, which should lead to a similar performance contour.

In order to minimize tracking error amid coupon payments, new issues, refinanced loans, re-ratings and index adjustments, without a sizeable cash or non-loans filler allocation, and the burden of week-long or longer settlement times, we are limiting liquidity to monthly. This will allow our portfolio managers adequate time to raise cash and realign the portfolio as needed. This is something our team is adept at, as we manage a number of index-tracking high yield ETFs. The settlement aspect of trading daily cash flows makes it nearly impossible to reasonably expect tight tracking error and a commensurate beta.
Tapping the new issue market helps reduce transaction costs, and provides a source of new, fresh funding to offset coupon payments and refinanced loans. As one of the largest trading partners in the asset management industry, our trading team has built strong relationships with brokerage firms and other counterparties, which are instrumental in the implementation process. Cost efficiencies are fully realized by clients in our loans strategy—just as they are in our high yield portfolios.

4. How do tracking error volatility (TEV) and performance expectations compare for State Street Global Advisors’ indexed loan strategies versus strategies in other asset classes, and versus other active loan managers? How does our custom universe benefit TEV and performance?

In our recently launched BB/B equal-weight $500M+ leveraged loan index strategy, we estimate coverage of roughly 40% of the index constituents, which would adequately represent the beta of the index, and allow us to align with its risk characteristics. We have a strong track record of performance in similarly-covered high yield strategies in which TEV ranged between 20-40 basis points (bps). We’d estimate that performance in this strategy will be close to that of the custom index, and factoring in transaction costs when we deem secondary markets necessary, we would feel comfortable with performance +/- 20bps of the index in a typical year.

For broader mandates, including those benchmarked against the Morningstar LSTA Leveraged Loans Index, we estimate issue coverage would be closer to 30%. With less overall constituent coverage, specific areas with less representation in the strategy would be the sub-$500M facility size, sometimes referred to as “middle-market” loans. While there is a bit of return premium in this cohort of the Index, it is largely invested in by private credit investors, and both access to and trading in these loans is extremely limited. As a result, tracking error in our stratified sampling approach, versus the broad loans Index, would be elevated relative to other high yield portfolios, as well as to our BB/B equal-weight $500M+ strategy. We estimate TEV to be closer to 50-80bps over most periods. However, while TEV may be elevated, the performance advantage of this sub-$500M facility cohort, in its size (~10% of the broad market), is generally not large enough to make a meaningful impact. By comparison, active managers’ typical TEV to the broad index ranges between 150-300bps per annum. Again, most of these smaller loans are secured by private credit managers, not the typical active leveraged loans managers in the space.

5. What type of client is best served with an indexed approach to leveraged loans investing?

In our view, institutional or long-term investors without a need for daily liquidity, and who typically have a strategic asset allocation framework, are ideal. With a lower-cost approach as we have developed, not only will we focus on obtaining the asset class’s beta return by investing along the index’s risk characteristics and limiting transaction costs through trading efficiently, but we will allow clients to allocate a greater portion of their fee budget to asset classes generally suited for this type of institutional investor. This includes private credit, distressed debt, and areas of the capital structure that warrant active management and associated fees.

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