Emerging Markets Equities

The Problem with Benchmarks

Constraints for unconstrained bond managers?
28 May, 2018
Fixed income benchmarks can help evaluate active fund managers with conventional investment objectives. But unconstrained managers march to different drummers; for these managers, benchmarks can be more of a hindrance than a help.
The ubiquity of the Bloomberg Barclays Global Aggregate Index is due to its comprehensive reach of investment grade debt securities which cover 24 local currency markets and 84 countries. This has made it a common proxy for the asset class, but its use of debt weighting can create unintended consequences for investors seeking to avoid risk or to maximise value. With few other widely accepted fixed income benchmarks, it has been more common for fixed income fund managers to not use an index to benchmark their performance. In such cases the managers believe the risks and opportunities in an index are too narrow and lack diversification. They also believe that outperforming such a benchmark and measuring the volatility in their portfolio relative to that benchmark will restrict investor outcomes.

A better balance of risks

Debt weighted indexes reflect the full volume of debt issued by investment grade countries, companies or organisations. In a global index, this means an investor will end up with large allocations to the world’s most indebted countries - many of these run budget deficits or have relatively lower discipline in costs versus revenue. An additional problem is that in the low interest rate environment of recent years, developed market governments have been issuing large amounts of debt at very low yields.  An investor guided by a world government bond index will have a bigger holding of debt issued by Japan, yielding 0.1%, rather than countries like Australia or New Zealand, yielding 2.5%.

For a broader index like the Global Agg (that covers government and corporate debt), debt weighting results in allocations that are disproportionately made up of government debt, much of it with greater interest rate sensitivity rather than credit risk.  

As of 30 April 2018, the Bloomberg Barclays Global Aggregate Index was made up of 54.2% of government debt (see Figure 1). The index offered a total yield of just 1.9%, with many of the underlying securities paying a yield below 1% and a fair share rewarding a negative yield. Such a low yield may offer little protection to shocks that could lie ahead.

Looking at the sector allocation too, a manager who is benchmark driven will be guided by industry weightings in the benchmark. Financial services companies, for instance, make up almost 40% of the corporate sector.

Figure 1: big universe, limited selection

Source: Bloomberg Barclays Global Aggregate Index, as of 30 April 2018
An unconstrained manager concentrates investments in countries, currencies and sectors where they see the greatest total return opportunity. Figure 2 shows how such value decisions are taken by assessing the real yields (yields minus local inflation) offered by issuers of government debt. The chart shows emerging markets such as Brazil, Russia, South Africa and India are attractive at current levels, given the drop-in inflation in those countries. This contrasts dramatically with the European developed market stalwarts of the UK and Germany, whose real yields are negative as rates remain at record lows.

Figure 2: real 10 year bond yields

Source: Bloomberg. Data as of 30 April 2018 - based on 12 month % change of headline CPI
An additional unintended consequence of investing relative to a government bond index is that a bond’s weighting rises as its currency appreciates. This means indexes can be biased towards markets with overvalued currencies with a greater price risk. Conversely, when currencies are undervalued and have the most potential to appreciate, their index weights are at a minimum. From an investment standpoint this is counterintuitive.

Non-investment grade bonds

Another drawback of global bond indices is that they don’t cover the entire investment universe. Among the most common bonds that an unconstrained manager will research will be local currency emerging market debt, emerging market corporate debt and global high yield. Most of those sectors are not included in the Global Aggregate index.

Similarly, many EM countries are not included in world government bond indices. Developing economies whose debt capital markets are rapidly evolving and deepening are underrepresented due to those issuers’ low debt market-capitalisation. They can also be underrepresented due to their credit ratings’ lagging an improved creditworthiness for the economy.

These bond sectors and regions have less research carried out on them than those included in the major global bond indices. Partly as highly regulated investors or risk averse investors will either not purchase them or buy them in limited quantities. This gives active managers a greater opportunity to discover bonds whose full value is not priced in.

Managing duration risk

The greater the duration in an index, the greater its sensitivity to changes in interest rate expectations and the likelihood of capital erosion in a rising rate environment. Figure 3 below shows how far duration risk has grown in the Bloomberg Barclays Global Aggregate Index. This means, an index-driven investment strategy implies taking on more interest rate risk in low-yielding countries and less in higher-yielding countries – the opposite of what a rational investor might want.

An unconstrained manager has more flexibility to manage duration risk. So, they can select securities which they think will rise in price and avoid those viewed as the most expensive, based on information about a country’s economic and interest rate outlook.

Figure 3: Yield v Duration - the bloomberg barclays global aggregate index

Source: Bloomberg Barclays Global Aggregate Index, data as of 30 April 2018

Smarter trading

Unconstrained fixed income managers can have portfolios of several hundred securities, while the Barclays Bloomberg Global Aggregate Index currently has approximately 21,000 issues. The trading costs on a smaller portfolio should be cheaper, while an index of so many securities will be difficult to efficiently replicate. Unconstrained managers can also trade in the primary market at any time to obtain new issues at yield premiums. These are typically not available to many passive managers, who trade only at month end. They also have the flexibility to trade in investment grade debt that does not meet the minimum size of issuance to be included in the index ($300m for US issued debt), as well as in securities that are too close to maturity to be included in the index.

Conclusion

Unconstrained managers believe the limitations of debt-weighted indices make it harder to achieve all the outcomes an investor may want from fixed income. And while active management does not ensure gains or protect against market declines, such managers believe searching the entire bond universe makes it easier to construct portfolios to help meet the following client needs:
  • An income that matches a particular liability stream.

  • To protect value/ avoid volatility.

  • Using the widest range of fixed income instruments to produce a unique source of alpha uncorrelated to fixed income or equity benchmarks.

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.

Please note that an investor cannot invest directly in an index.

Unmanaged index returns do not reflect any fees, expenses or sales charges.

Important Information:

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.

This material is only for distribution in those countries and to those recipients listed.

All investors in the UK, professional clients and eligible counterparties in EU and EEA countries ex UK and Qualified Investors in Switzerland.

Issued and approved by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444.

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC. The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission. Investors should read the offering document prior to any subscription. Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only. Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia:

This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) ("Legg Mason"). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client's professional advisers.

© 2018 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC is a subsidiary of Legg Mason, Inc.