The loud debate between active and passive investors has an echo in the more subtle discourse between active and passive fund providers.
Whenever the active industry highlights a perceived flaw in passive theory, a rebuttal tends to arrive in the form of a new product. Arguments that index investors must accept the full force of market dips have for instance been met with various low-beta or low-volatility funds.
Within fixed income, the criticism has been that traditional bond indices carry excessive exposure to the most indebted issuers. One response has been indices weighted by the issuers’ fundamentals, rather than their market capitalisation.
The academic response
A new paper in a forthcoming issue of the Journal of Asset Management indicates this will not be the definitive answer to sceptics of passive bond investing.
Across a range of fixed-income markets, Vanja Piljak of the University of Vaasa in Finland and Laurens Swinkels of Erasmus University Rotterdam found that fundamentally weighted bond portfolios did not consistently deliver superior risk-return performances to conventional bond indices, especially once currency effects were excluded.
They considered several broad bond sectors, weighted by four fundamental factors proposed by Research Affiliates: population, land area, GDP and energy consumption. Each is essentially a proxy for an issuer’s ability to raise money and meet obligations to creditors.
The first grouping was investment-grade local-currency sovereign bonds, derived from the Barclays Global Treasury index from 1987 to 2015. The highest annual excess return from any of the fundamental weightings here was only 4 basis points for the area and energy measures when the returns were hedged back to dollars.
Trimming the hedge
On an un-hedged basis, however, the fundamental indices’ performance was much better. When currency was a factor, the annual excess returns ranged from 0.26% for GDP to 1.43% for area with the average risk-adjusted excess return statistically significant at 1.29% a year.
Turning to emerging-market local-currency debt, using the Barclays Emerging Markets Local Government Universal index between 2008-205, excess returns from fundamental indexation were again only substantially higher than market-cap weighting when the exposure was un-hedged.
‘These results suggest that currency forward returns and not fixed-income returns are related to country fundamentals,’ remarked Piljak and Swinkels.
‘Our results do not rule out that fundamental weighting schemes cannot work for government bond markets, but that the four fundamentals discussed in the literature do not seem to generate robust risk-adjusted returns,’ they concluded.
‘This might be due to the difficulty of relating a country’s fundamental size to its bond-market returns, as factors such as political risk or the safe-haven nature of US and Japanese bond markets might be more important drivers.’
There are two principal implications for investors considering fundamental indexation in fixed income.
First, the approach seems to be a play on currency rather than bond markets, with the benefits mainly apparent in un-hedged strategies.
And second, the excess returns generated by fundamental weighting can be so low as to be measured in single basis points, so it is not likely to be worth paying a high premium for such a fund.