TDFs cast a wider net of investable options to help enable greater portfolio diversification. To maximize the value of the diversification, fund managers should scrutinize the underlying indices being tracked and determine how to control for issues inherent to these investments. For example, consider the indices State Street uses for both commodities and high yield — two asset classes that are rarely found in index-based TDFs, given concerns related to the efficacy of index-based implementation.
Commodities: Importance of Roll Returns
When evaluating commodities as part of State Street’s regular asset class selection process, we were concerned that passive investors might not be able to fully reap the diversification and inflation-hedging benefits due to the roll risks. Working with members of our Global Equity Beta Solutions team (GEBS), we evaluated multiple commodity indices and selected the Bloomberg Roll Select Commodity Index. Following a rules-based approach, the Roll Select Commodity Index seeks to limit the effects of roll risk (or “contango”), which can adversely affect passive commodity investors who are neither watching nor adjusting for the rise and fall of commodity futures. Since adding this asset class to our TDFs in June 2012, the Roll Select Commodity Index has outperformed the first-generation Bloomberg Commodity Index by 1.2% on an annualized basis.2
High Yield: Managing Liquidity Risk
High yield (HY) investing offers the benefits of equities and fixed income while potentially limiting the downside risks associated with both. Used properly within a glidepath, it allows a manager to increase savers’ expected balances while also protecting against longevity risk after participants have exited the workforce.
However, HY does present the challenge of lower liquidity in the face of defined contribution (DC) cash flow requirements. That is, an HY indexer that uses a non-filtered index would be forced to hold illiquid HY securities that may suffer significantly in a market downturn if the indexer were forced to sell.
To address the strategy’s daily cash flow needs, State Street uses the Bloomberg Barclays US High Yield Very Liquid Bond Index (HY VLI). This index stands out by following simple, objective rules to deliver a liquid index while still retaining the potential benefits of HY investing. The benefits of our index selection can be quantified by the low degree of tracking error (average monthly variance of -0.04%) and strong correlation to the broader Bloomberg US High Yield Index (0.99) since its addition to our glidepath in January 2010. Furthermore, while some index-based managers argue that it is necessary to employ active management when investing in HY, the HY VLI index has delivered above-median results when compared to the Morningstar universe of active managers.