The new investor

“Know what you own, and know why you own it” – Peter Lynch

For as long as most can remember there has been ongoing debate over whether investors should be utilising active or passive approaches to investing in fixed income markets. From our perspective, such a debate runs the risk of missing the key question of “is the investor achieving their desired investment outcome?” And not “how closely are their investments tracking a particular benchmark?”

The choice of a benchmark is a means to an end not the end itself. Put another way the issue is less about whether active or passive is better but rather whether investors have confidence in the appropriateness of fixed income benchmarks to reflect their desired investment outcomes not only at a point in time but over time. The reason for this is investors really should be focusing on the absolute outcomes generated by a fixed income portfolio rather than the benchmark relative risk characteristics of a portfolio.

In this sense whether an investor regards themselves as active or passive is irrelevant as in practice every investor needs to consider themselves as a proactive investor.

A benchmark is not necessarily your friend!

The central issue facing investors, with respect to selecting a fixed income index to serve as a benchmark, is the complexity inherent in fixed income markets and the resulting implications for the construction of the associated indices. Given (a) the broad range of fixed income securities and (b) the lack of central clearing/pricing exchanges, traditional fixed income indices establish specific criteria for determining which fixed income securities will be included in an index and how the weightings will be established. The result is that, not only are fixed income indices by necessity a subset of the investible opportunity set available to investors, but there also tends to be a wider range of usable fixed income indices which could be potentially used as benchmarks. Differentiating between each potential benchmark is complicated as each is trying to capture a different part of the fixed income market rather than capturing what may be termed ‘the entire’ fixed income market. It is for this reason the overall risk characteristics of a fixed income index becomes more relevant to an investor than the exact nature of the individual securities included in the index; i.e. the factors the investor is exposed to in an index are more important than the precise way in which those factors are assembled.

Complicating the choice of a benchmark is not only the range of indices available but that, as traditional fixed income benchmarks are constructed on the basis of outstanding issuance ¹, the resulting risk characteristics of the indices are therefore driven by the actions of market participants, i.e. the issuers. This focus on issuance outstanding not only results in changes to the risk characteristics of an index over time as issuance patterns change/evolve but also tilts the indices exposures increasingly towards the largest borrowers within the subset. This creates a dilemma as the general risk characteristics of an index being used as a benchmark may not coincide with an investor’s desired risk characteristics, and more importantly even if they do at a point in time there is no certainty it will continue to do so over time. This has important implications for both active and passive investors as the definition of the appropriate benchmark is essential for establishing the ‘neutral’ medium term absolute risk/return characteristics desired by the investor.

Don’t focus on the wrong measure of risk!

While in the opinion of Russell Investments, the focus of investors should be on considering the outcome in terms of absolute results often the active versus passive debate is phrased in term of outcomes relative to the benchmark. The danger with this type of focus is the investor is at risk of becoming largely indifferent to the overall risk characteristics of the selected benchmark with the focus instead being on tracking error, or potential mismatch versus the benchmark, as the definition of risk. This can lead to some perverse results with respect to risk management especially where a benchmark is relatively concentrated. Namely, by focusing on tracking error as the relevant risk characteristic an investor may be increasing other forms of risk.

To highlight this point, recall that the exposures in a fixed income index (a) represent just a subset of the investible universe and (b) are biased towards the largest issuers of debt. As a result of such characteristics traditional indices may not necessarily represent the optimal risk/return outcome for an investor; i.e. not representing the best risk/return profile for investors.

For example, consider the situation where a benchmark may be relative concentrated with the major driver of risk being domestic credit premiums. Now assume an investor introduces a range ex-benchmark exposures/premiums within the portfolio which exhibit a low correlation to domestic credit premiums². Any simple statistical analysis based on tracking error and returns would conclude that the addition of such exposures has resulted in a deterioration in expected outcomes as tracking error has increased while expected returns are unchanged. But is that really the case? While there is greater tracking error, the increased diversification of premiums has materially reduced the absolute risk faced by the investor. Not only has the addition of ex-benchmark exposures added to the diversification of return sources but it may have also reduced the exposure to default risk by adding a more diversified pool of credit and/or reducing the investors reliance on domestic credit as the key source of value add.

This simple example seeks to highlight how a focus on tracking error can have the effect of exposing the investor to increased risk especially where a benchmark may be relatively concentrated. Not only that but the risks of the benchmark will be changing over time and consequently so will the range of risks the investor is exposed to. Due to the nature of fixed income indices there can arise the rather perverse result in that by trying to minimise tracking error an investor may actually be increasing the total risk profile of their portfolio. It is for this reason that Russell Investments views that investors really do need to focus on the absolute risk characteristics desired within their portfolio and then by extension the chosen benchmark.

Know what you own, and know why you own it

When constructing a portfolio an investor needs to start with the basics which entails knowing their own medium term risk/reward preferences as well as ‘knowing the benchmark’ not only at a point in time but over time. When selecting a benchmark investors need to ensure they utilise a fixed income index which represents their desired risk characteristics over a full cycle. This requires they understand and define their desired risk characteristics or beta. Such risk characteristics could include specifying criteria according to measures such as:

• Interest rate duration
• Credit spread duration
• Average or minimum credit quality; i.e. level of desired default risk.
• Total volatility
• Desired diversification characteristics both within fixed income and between fixed income and other asset classes
• Other requirements such as income needs, prohibited securities etc.

Once this has been done, one approach is for the investor to look for an appropriate traditional index which best approximates the desired range of risk characteristics. Having done this, the investor can decide whether they should either invest passively or undertake some form of proactive management via the introduction of exposures which differ from those of the benchmark³

The introduction of such ex-benchmark exposures becomes more important if the benchmark chosen is deemed to be concentrated thereby providing lower levels of diversification.

The important point worth stressing is that whichever approach is selected, the onus is still on the investor to ensure overtime, as issuance patterns change, the underlying absolute risk characteristics of the portfolio remain consistent with the investor’s desired strategic risk characteristics. Accordingly, the investor will need to proactively monitor and manage the structure of the exposures to ensure consistency over time.

Be a proactive investor

For some fixed income investors the use of a standard broad market benchmark as the basis for constructing fixed income portfolios, either active or passive in nature, may provide adequate approximations of their desired risk return characteristics. However, given the approach taken to constructing most traditional style benchmarks, investors must be careful not to take for granted that the benchmark reflects their risk/return characteristics, nor that it will continue to do so over time. In this context the debate over active vs passive management misses the key point. In the opinion of Russell Investments, investors need to be continually proactively monitoring and, if need be modifying, portfolios and their benchmarks so as to ensure over time they remain consistent with their absolute risk tolerances. We believe it is this proactive management of portfolio exposures which facilitates the ability to create more efficient portfolios especially where the traditional fixed income indices are more concentrated. The ability to create more efficient portfolios is just as important, in our view, as a contributor to superior returns for investors as the more traditional explicit directional views which investors normally associate with active management. Accordingly, the distinction between being an active or passive investor becomes blurred when one considers ‘all investors should be proactive investors’.

¹ In the context of this article the concept of a traditional fixed income benchmark refers more broadly to any benchmark which either explicitly or implicitly utilises the level of issuance outstanding when determining the weighting of a particular issue within all or part of the index. Accordingly GDP weighted benchmarks which utilise liquidity inputs/overlays are also included in the scope of traditional fixed income benchmarks.

² To simplify the discussion it is assumed that the ex-benchmark exposures/premiums are expected to generate the same returns as domestic credit premiums over the medium term.

³ In Russell Investments’ view it is important to distinguish between what is the traditional concept of active management and what Russell Investments refers to as ‘proactive management’. Active management, is defined as the intentional deviation of portfolio characteristics away from those of a predetermined benchmark based on a specific directional outlook for the economy and/or financial markets. It is worth contrasting this with what may be termed proactive management which can be viewed as being the management of the more medium term characteristics of a portfolio to ensure the risk/return characteristics of the portfolio are consistent with those desired by the investor. The key difference between active and proactive management is that one is driven by a definite directional view regarding financial markets whereas the other isn’t.