Indexology^® Blog

It’s widely known that Black Friday, the Friday after Thanksgiving, is the traditional kickoff for the Christmas shopping season. Much like retail shoppers, Wall Street is experiencing a similar event though it does not come with such a defined time period. Early indications of companies attempting to time corporate issuances came in September of this year when Verizon Communication Inc. issued $49 billion corporate bonds just prior to the Sept. 18 FOMC rate decision.  These bonds were very well received by the investor community and, for the bonds that met qualification rules, were eventually added to the S&P U.S. Issued Corporate Bond Index.

It was reported in the press that Verizon executives wanted to sell as many bonds as possible the first time around. By wrapping up the financing early, Verizon essentially eliminated the threat of rising interest rates. The S&P/BGCantor Current 10-Year U.S. Treasury Index’s yield-to-worst had risen 19 basis points from the beginning of the month leading into the September Verizon deal, as market participants worried about the effects of Fed tapering. After the announcement and reassurance of continued stimulus, the index’s yield-to-worst advanced lower, eventually reaching a low of 2.50% on Oct. 23. Since then, yields have started trending back up and discussions have been renewed surrounding the timing of any action in regard to the Fed’s tapering of its stimulus purchases.

As a result of these trends, corporate issuers are once again looking to time their issuance before any significant rate action occurs. The next FOMC meeting is scheduled for Dec. 17-18, and already we’ve seen issuers such as Microsoft Corp. ($3.25 billion) and Johnson & Johnson ($3.5 billion) come to market with issues spanning maturities from three years to 30 years out. The majority of issuance for these two deals meets the S&P U.S. Issued Corporate Bond Index qualification rules except for the $800 million Johnson & Johnson floating rate notes due 11/28/2016, which, as stated in the index methodology, are excluded for not being fixed rate. The demand for yield is strong and the recent increase in rates has whet the appetite of investors while still remaining attractive to corporate CFO’s. We could see further corporate issuance this year as firms attempt to secure financing before any possible increase in rates may occur.

Yesterday’s Wall Street Journal offered a profile of fixed income investors who aim to “break [the] chains” by which they are supposedly confined by index benchmarks.

As the bond market falters, investors are seeking shelter in funds that aren’t tied to indexes.  These bonds funds are known as “unconstrained,” “go-anywhere,” “absolute return” or “flexible” funds, and they are gaining in popularity on both sides of the Atlantic…

This echoes a theme we also hear in the equity markets — that managers need to be “more aggressive” (typically by holding fewer stocks) in order to improve their performance.

Improving performance is not quite as easy as the article implies.  Moreover, investors, both institutional and individual, compare managers to indices for a very good reason.  The reason is that absent some objective standard, the fund owner has no way to judge whether the asset manager’s performance was good, bad, or indifferent.  Admittedly, “some objective standard” covers a lot of ground — not losing money in a quarter, or earning at least 10% a year, are both objective standards.  But indices are uniquely well-suited to be the standard by which asset owners evaluate asset managers.

Most broad market indices — whether they measure equities or bonds — are capitalization-weighted.  Such an index will accurately reflect changes in the total market value of the asset class in question.   One of the most important characteristics of any asset class is that there is no net supply of alpha.  In other words, one manager can be above average only if another manager is below average.  The aggregate amount by which the above-average managers outperform the asset class must equal the aggregate amount by which the below-average managers underperform.

By comparing manager performance to that of a well-diversified, cap-weighted index, an asset owner realizes two benefits:

• He assures himself that his bogey is reasonable in view of the opportunity set available to his managers.  In 2011, with the S&P 500 up 2%, it would have been foolish to expect a U.S. equity manager to meet an absolute 10% bogey.  This year, with the 500 up 29% through November 30, it would be equally foolish to be satisfied with 10%.
• Since there is no net supply of alpha, roughly half of all managers will outperform their asset class and roughly half will underperform.  As a convenient shorthand, a manager who beats a well-diversified cap-weighted index is likely to be an above-average manager.

There are as many putative paths to outperformance as there are active managers (or active managers’ marketing departments, which is more or less the same thing).  None of them will be impeded by asset owners’ use of well-chosen indices to evaluate manager performance.

Globally, over 6 billion U.S. dollars are invested in India Equity ETFs, although less than 200 million via products listed in India.  It’s reasonable to suppose that Indian demand is reflected in the local figures, transferring wealth across Indian borders is both difficult and expensive.  Thus, on the face of it, these figures suggest general indifference to passive investing within the Indian financial community, despite substantial passive interest in India from outside its borders.

The debate between proponents of passive and active investing has been raging for close to a century.  And when it comes to India, the evidence favours the passive investor, much as it does in more-developed markets.  But – in India as much as elsewhere – very few investors are limited to a single asset class.  From the perspective of a multi-asset portfolio, the real picture is much more complicated, and potentially more rewarding.

When looking across asset classes, there is no universally-agreed definition of what ‘the market’ actually is.  In the absence of a widely-accepted bogey, in practice investors frequently build their own: a benchmark comprising a custom blend of markets across a variety of asset types and geographies, representing their overall allocations.  And here’s where it gets interesting.  The impact of changing asset allocation is usually much more significant than changing an individual component benchmark, or changing a component between active or passive allocations.   An investor, manager, advisor or consultant adds the most value when he gets his asset allocation right.  And given the time and effort spent on choosing individual managers, arguably the most efficient way for an investor to spend his time is to focus on actively managing an asset allocation among passively managed components.  In fact, a key driver of ETF growth across the world – ranging from US financial advisors and institutions, European macro-funds and through Asian retail investors – is through such active management via passive asset allocation.  Sometimes old foes can find a new partnership.

These are important considerations for investors in India and elsewhere.  To learn more, please join us for a live 60-minute webinar on December 12, 2013 to hear from practitioners at Kotak Mutual Funds and S&P Dow Jones Indices.  We’ll discuss the trends, opportunities and challenges in investing actively through passive building blocks.

Robert Shiller, Yale economist and author of Irrational Exuberance, who warned of 2000 Tech bust and the housing bubble is warning that equities may be a bubble. Year to date, the S&P 500 is up 26.7% and the Dow Industrials are up 22.4%, both before dividend reinvestment.

It may have been 30 years ago, in the early days of stock index futures, that the verb “equitize” (and its cognate noun, “equitization“) came into relatively common use.  The term, if Dr. Johnson will forgive me, meant “to provide equity returns without purchasing equity securities.”  Typically this was accomplished by buying S&P 500 futures — if I had a $10 million cash position, I could “equitize” it  by buying S&P 500 futures with a notional value of $10 million.  Unless I’d made a severe arithmetic error, the total return of my cash + futures position would very closely approximate that of a $10 million S&P 500 index fund; hence my cash had been equitized.

For unknown reasons, “bonditize” or “bondize” never caught on.

I propose that indicize (and its noun form, indicization) will sooner or later find their way into common use.  To offer an inelegant definition, indicize means to provide, in passive form, a strategy formerly available only via active management.  Consider, e.g., a hypothetical investor who wants to tilt her portfolio toward small-cap growth stocks.  Thirty years ago, her only option was to buy a mutual fund whose manager avowed a specialization in small-cap growth, and then to hope for three things:

1. That the manager shared the investor’s definition of small-cap growth
   
2. That the manager didn’t change his mind (for instance, by deciding that large-cap value offerered better opportunities this quarter) during the investor’s holding period
3. Most importantly, that the manager’s stock selection ability, if not positive, was at least not so negative that it overcame the putative benefits of being in small-cap growth in the first place.

Since then, of course, advances in passive management mean that a strategy like small-cap growth is easy to indicize.  (Today our hypothethical investor’s main problem would be to decide which of several ETFs or mutual funds specializing in small-cap growth she’d prefer to buy.)  There’s no need to expose herself to the vagaries of active management when a passive solution can provide efficient and inexpensive exposure to the factors about which she really cares.  And of course indicization isn’t limited to size and style portfolios, but extends to other themes — low volatility comes immediately to mind — as well.

This makes the active manager’s life harder.  In former days, he could expect to be paid both for providing access to factor exposures as well as for stock selection; today, he’s increasingly limited to stock selection as factor exposure is indicized.  For the same reason, indicization is an unambiguous benefit for the investor.