Benchmarks have long served as a starting point, or anchor, representing the neutral point for an investment decision. They serve as the basic ingredients that combine to form an investor’s asset allocation and result in a desired risk-return profile.
A market capitalization approach to benchmark construction has been the norm for decades. In the equity markets, this approach means that an investor’s neutral allocation will have the most exposure to the companies with the highest market cap and the least exposure to companies with the smallest market cap. In the debt markets, a similar approach prevails: Investors allocate more capital to the countries and companies that have the most debt outstanding.
But is this the best way to think about investing? At PIMCO, we believe investors may be better served by adopting a slightly different approach to benchmarking: using a smarter beta that disentangles price or debt levels from the index construction process.
Let’s start by examining indexes in the equity markets. In a traditional benchmark, each company’s weighting is a function of the number of outstanding shares ?times the price per share. An investor cannot know at a given point in time whether that price is the correct value, however. If markets are perfectly efficient, then the price is assumed to be correct. But markets may not always be perfectly efficient.
Take technology, for instance. The sector became more than 44 percent of the global equity market’s value in early 2000, so that a neutral allocation based on a traditional index would have put almost half of an investor’s capital into this segment — despite the fact that at that point in history many tech firms had yet to show positive cash flows or pay dividends. Similarly, in 2006 the financial sector became more than one third of the global equity market, and in the late 1980s Japanese stocks represented 44 percent of the market. In each case, an investor using traditional indexes was making the implicit bet that these segments would contribute the same share of global profits in the coming years. Sadly, in all three cases, the respective markets declined by some 45 to 50 percent.
The same phenomenon occurs when looking at individual equities. Newport Beach, California–based investment management firm Research Affiliates has reported that the highest market capitalization stock in the MSCI World index has underperformed the index as a whole 73 percent of the time over subsequent three-year periods and 91 percent of the time over subsequent ten-year periods. Thus the performance of high-flying stocks historically has not kept pace with what had been implied by starting valuations.
One alternative approach to market cap weighting takes price out of the equation and replaces it with measurable economic fundamentals, such as sales, dividends, cash flow and book value. By using this approach, an investor can often avoid introducing pro-cyclical tilts, which allocate increasing capital to equities that move up in price. PIMCO has found that a smart beta approach, using economic fundamentals rather than stock prices, helps to reduce risks. Unless the underlying fundamentals have commensurately improved, a natural sell discipline ensures that stocks that have posted strong recent performance are automatically reduced in weighting during index rebalancing.
To implement a smart beta strategy, investors can passively invest in a basket of stocks rebalanced as described above. Whereas this offers simplicity, it leaves potential alpha on the table. An alternative is to combine aspects of passive management with the benefits of active management: specifically, by obtaining equity exposure to a smart beta index passively via total return swaps and at the same time investing the cash collateral for the swap in an actively managed, high-quality bond portfolio.
When combined, this portable alpha approach is designed to provide a portfolio with broad equity market exposure and a volatility profile similar to a purely passive portfolio but with the potential to deliver equity market outperformance, should the bond portfolio outperform money market rates.
The same principles of designing benchmarks and beta based on fundamentals rather than market capitalization can be applied to bond markets. In traditional bond indexes, weightings are based on the par value outstanding times the price of a bond. This often results in a potentially wrongheaded situation: A bond investor lends the most money to the most heavily indebted countries or companies. Japan might be an extreme example of this scenario. The country has a debt-to-GDP ratio of more than 200 percent and is one of the largest economies in the world, which means it has a large amount of outstanding debt. As a result, its weighting in a broad investment-grade bond index today is more than 16 percent, but it currently offers yields of less than 0.50 percent for ten-year government bonds.
An alternative approach that PIMCO has adopted for some clients uses GDP, rather than debt outstanding, to determine benchmark representation. In this way, an investor moves toward a portfolio that is more representative of global economic output. According to the International Monetary Fund, emerging markets now represent about 50 percent of global GDP, and yet they have significantly less debt outstanding than their counterparts in the developed world.
As with equities, passive approaches to fixed income may offer simple implementation. But here again, especially in a world of low interest rates, potentially valuable alpha may be left behind. Over time, skilled active managers can take advantage of structural inefficiencies in the bond market, such as:
• So-called clientele effects, in which certain investors must focus on bonds with specific ratings or maturities
• Dislocations between derivatives and physical bonds, which allow managers to arbitrage differences in pricing on an unleveraged basis
• Intervention by central banks and other official institutions that may distort values in segments of the market like government bonds, mortgage-backed bonds and asset-backed securities
• Exchange-traded funds, which may use narrowly defined indexes, creating arbitrage opportunities on individual securities amid heightened inflows or outflows.
As a result of these inefficiencies, we believe investors should try to get the most from their fixed-income allocation in this way: Combine a smart beta approach (one based on economic footprint) with the benefits of active management (to take advantage of opportunities in the bond market) to generate alpha.
Whether investors pursue a purely passive approach or a portable alpha strategy that combines passive investing with active management, a smarter benchmark may provide a better starting point for investment decisions.
Ryan Blute, based in Munich, is a managing director responsible for Pacific Investment Management Co.’s business in Germany, Austria and Italy.
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