Fixed-Income Benchmarks Become More Customized

Fixed-income benchmarks have come a long way from when the Bloomberg U.S. Aggregate Bond Index was the main tool asset managers and asset owners used for performance measurement.

Improvements in technology and data collection, combined with more robust niche markets, make it feasible for index providers to build benchmarks that include more asset classes beyond traditional fixed-income markets. Custom indexes can incorporate esoteric asset classes and also may be structured to include factors not previously considered, such as interest rates, duration and economic scenarios.

Customized indexes can bring more accountability and transparency to the asset owner and manager relationship, says Katie Cowan, head of insurance client solutions at First Eagle Investments.

For complex portfolios, custom benchmarks can be an improvement over traditional indexes, since they can track closer to an asset owner’s targeted hedging portfolio; however, they are not a perfect solution, wrote Aaron Chastain, a principal and the corporate solutions leader at NEPC, in an email.

“A hedge ratio of 100% for interest rates and credit spreads still cannot create a perfect hedge against economic outcomes, demographic outcomes and assumption changes,” Chastain wrote.

Rethinking Fixed Income

The convergence of several trends, including improved funded status for pensions, falling duration liability, increased hedge allocations in portfolios and a wider tool set has helped usher in changed views of fixed-income strategies, says Jared Gross, head of institutional portfolio strategy at J.P. Morgan Asset Management.

Cowan says because macroeconomic uncertainty and market volatility are hallmarks of today’s financial environment, diversification is becoming important for risk management. However, she says, “there is no natural one-size-fits-all benchmark” for asset classes in areas such as structured credit, a popular asset class that offers higher yields than traditional corporate credit.

Gene Podkaminer, an institutional investment strategist at Capital Group who has worked with both asset managers and asset owners. says benchmarking fixed-income portfolios against the Bloomberg bond indexes, whether it be the U.S. Aggregate or the U.S. Universal or the Global Aggregate, “does not necessarily capture the beta exposure that is in that (asset manager’s) strategy.” He adds that compared to equities, fixed income has more factors to consider, especially for complex fixed-income portfolios.

Asset owners interviewing managers should have a clear understanding of the strategy’s beta exposure and what value the managers add.

“To do that, [they] really need to have a deep and nuanced understanding of the benchmark,” Podkaminer says. “Not necessarily just what the benchmark next to a strategy is in some system, but looking through the strategy and thinking, ‘Does that compute for this manager?’”

Building Indexes

Jarrad Linzie, head of fixed-income index research at MSCI, says asset owners are starting to look more closely at the efficient-frontier model, and not just for returns and standard deviation. They are also studying the liquidity and volatility of other asset classes the investor may add, to help ascertain whether a particular strategy is realistic and replicable. Because of the increased amount of data available and stronger computing power, it is easier than in past years for indexers to customize and back-test these strategies.

Asset owners are also looking for ways to reduce risk from nonfinancial factors such as macroeconomics, Linzie says. For example, an asset owner may contemplate adding European or Asian issuers to their portfolio to offset concerns about U.S. tariffs.

Additionally, asset owners working with constraints, whether due to regulations or to mandates such as sustainability, can create indexes that are mindful of the guidelines, but avoid sacrificing returns. For example, a dozen years ago, sustainability-minded clients may have accepted lower returns, Linzie says, but no longer.

“Fast forward to today: That’s not happening,” he says. “They’re not sacrificing anything.”

NEPC’s Chastain wrote that advisers who work with clients to build a customized index seek to clearly define stakeholder expectations and constraints to ensure the appropriate focus on results is maintained. 

Benefits and Challenges of Using a Custom Index

First Eagle’s Cowan says the biggest benefit for investors using a customized index is manager accountability.

“It gives the client a reference point to monitor the asset manager,” she says.

That’s the case, whether asset owners use the benchmark to monitor downside or upside performance, or use it to measure managers against each other if more than one is managing to a mandate.

Podkaminer says custom indexes allow more introspection on the asset manager side, as they are aware of how their strategies will be evaluated. It also gives asset managers a chance to be proactive when discussing performance, rather than waiting for questions.

One of the challenges to using a custom benchmark or a factor-based approach is how to explain to stakeholders what is happening in a portfolio, he says. It is easy to explain performance against the Agg, but harder against a custom benchmark, especially if performance is soft.

Not everyone is a fan of customized indexes. Chastain wrote their use is being driven by asset managers looking for business because de-risking and pension risk transfers have reduced the need for liability-driven investment portfolios.

Larger pension fund sponsors with unique needs, as well as significantly de-risked plans that are seeking hibernation for their fund, may benefit from customized benchmarks, but NEPC’s Chastain wrote, “We believe the majority of plans remain well served by a thoughtful implementation of [U.S.] Treasurys and corporate bonds, paired with completion management.”

Considering Tracking Error in Customized Indexes

J.P. Morgan’s Gross cautions that as pension funds create more-diversified portfolios to increase efficiency in their use of capital and generate attractive risk-adjusted returns, those that create custom indexes need to think about tracking error broadly.

“That benchmark-selection question is quite fundamental,” Gross says. “You really do have to make a choice as to where you want the tracking error to show up.”

Asset owners can build a very precise benchmark for their liabilities, or they can give managers benchmarks for each of their preferred ways to invest. However, the second option will not look as much like the liability. The industry is moving away from the goal of low-tracking-error benchmarking to something more flexible.

Cowan says if an asset owner prefers a low-tracking-error benchmark, it would be cheaper to use an exchange-traded fund, rather than pay an active manager.

The right answer, Gross suggests, is “having an efficient portfolio that delivers long-term excess return with risk that’s appropriate, relative to the liabilities.”

Tags: benchmarks, fixed income strategies, investment performance