Fixed income index construction needs more care and attention

If there is a problem to address with fixed income exchange-traded funds, it is not that many track indices. Where there are inefficiencies, it is that the indices they track have not been constructed properly, taking into consideration all the challenges and opportunities in the fixed income space.

More care and attention should be lavished on fixed income index construction to make the difference between fixed income and equity indexation an opportunity and not a challenge. 

Indices should not leave fund managers with huge gaps to make up between their theory and the market’s reality.

Making indices that include too many bonds ultimately forces the fund managers to optimise their portfolios. Optimisation per se is not a problem, unless there are large numbers of bonds or issuers who are simply unavailable and as a result trade very differently from the rest of the portfolio.

Often, a few thoughtful adjustments to index language can cut the turnover by multiple percent.

Many portfolio managers, using sophisticated portfolio management tools, can create optimised portfolios that balance the natural desire to fully replicate index constituents with the practical challenges and costs, while achieving more than 99 per cent accuracy of tracking.

But the bigger and more unwieldy the benchmark the more challenging this is.

Constructing an index

A good rule of thumb is if in doubt, include fewer bonds in an index and use data to try and make sure that they are actually available to own and trade. 

The second rule when constructing a fixed income index is to look at the impact on turnover of the rules that are implemented.

Poorly considered rules can create unintended turnover. One should remove a credit or instrument if it is clearly no longer offering exposure to the intended investment thesis but not let technical factors cause bonds to enter and exit the index purely because they cross a technical threshold.

Often, a few thoughtful adjustments to index language can cut the turnover by multiple percent.

It is important to remember that the main argument for index solutions is not the low fees (though they usually are on the low end), but the transparency, daily reporting and a systematic approach to managing risk.

Alleviating concerns

Index investors are rarely surprised by an unexpected concentration to one credit. They can see the progression of their investment exposure and ask questions if it is diverging from their expectations.

There is a general concern that passive fixed income ETFs can be used by both buy and hold investors and short-term traders.

There is a suggestion that traders take advantage of buy and hold investors.

It would actually seem that the relationship between short-term and long-term investors in ETFs is in fact quite symbiotic.

There is one theoretical concern about passive investing that equity investors have spent a lot of time contemplating.

Regular intraday trading creates an efficient secondary market for the ETF while using price discovery to ensure that on-screen prices accurately reflect the value of the holdings of the fund.

In fast markets, there is even evidence that ETF prices are a more accurate indication of the pricing of the underlying bond basket than any data service or trading desk can provide.

Also, very importantly, long-term investors do not suffer the gyrations of the ETF’s bid-offer. If new investors trigger a creation or departing investors result in a redemption, the trading costs of their entry/exit are passed directly to them, rather than impacting the fund. 

There is one theoretical concern about passive investing that equity investors have spent a lot of time contemplating.

Is there a point when the market’s shift to passive turbo charges momentum and gives power back to active investors not caught up in the vicissitudes of index rebalances?  

General calculations in equity suggest more than 25 per cent of assets are managed passively. Is this close to the point when the pendulum swings in favour of independent managers not tied to any benchmark?  

No one is sure. What they do know is that in fixed income around 5 per cent of assets are managed passively so we are nowhere near this inflection point. 

Michael John Lytle is chief executive of Tabula Investment Management