Benchmarks have long served as a starting point, or ‘anchor’, for investors, 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 – for both equity and fixed income markets. In the equity markets, this means an investor’s neutral allocation will have the most exposure to the companies with the highest market capitalization and the least exposure to companies with the smallest market capitalization. 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’ – one that disentangles price or debt levels from the index construction process.
Market capitalization weighting
Let’s start by examining indices in the equity markets. In a traditional benchmark, each company’s weighting is a function of its shares outstanding times the price per share. However, an investor cannot know at a given point in time whether that price is the ‘correct value’. If markets are perfectly efficient, then the price is assumed to be ‘correct’, but markets may not always be perfectly efficient.
For example, the technology sector became more than 44% 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 narrow sector − even as many companies 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, Japan represented 44%. In each case, an investor using traditional indices 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 45%−50%.
The same phenomenon occurs when looking at individual equities; Research Affiliates has shown that the highest market-capitalization stock in the MSCI World Index has underperformed the MSCI World Index 73% of the time over subsequent three-year periods and 91% of the time over subsequent 10-year periods. So, in fact, the performance of ‘high-flying’ stocks historically has not kept pace with what has been implied by starting valuations.
Smart beta alternatives: equities
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 when determining index weights. 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 these pro-cyclical risks. One reason: Fundamentals don’t change as frequently as stock prices; therefore, a natural sell discipline ensures that stocks that have posted strong recent performance are automatically reduced in weighting during index rebalancing (unless the underlying fundamentals have commensurately improved).
To implement a smart beta strategy, investors can passively invest in the basket of stocks represented in the smart beta index. While this offers simplicity, it leaves potential ‘alpha’, or excess returns, 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 pure passive portfolio, but with the potential to deliver equity market outperformance should the bond portfolio outperform money market rates. At PIMCO, we have used this approach since 1986.
Smart beta in bonds
The same principles of designing benchmarks and ‘beta’ based on fundamentals rather than market capitalization can be applied to the bond markets. In traditional bond indices, weightings are based on the par value outstanding times the price of a bond. This typically results in a potentially perverse situation: A bond investor lends the most money to the most heavily-indebted countries or companies. An extreme example might be Japan: The country has a debt-to-GDP ratio of more than 200% 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%, but it currently offers yields of less than 0.50% for 10-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 towards a portfolio that is more representative of global economic output and more forward-looking in nature. For example, emerging market economies now represent about 50% of global GDP, according to the IMF, and yet they have significantly less debt outstanding than their developed world counterparts. A GDP-weighted approach to bond investing would allocate more capital to this segment of the world, which, in many cases, also offers higher yields, albeit with the potential risk inherent in developing/emerging markets.
As with equities, a smart beta approach to fixed income can be achieved through either passive or active investment strategies. Passive approaches may offer simple implementation, but here again, potentially valuable alpha – especially in a world of low interest rates – may be left behind. Over time, skilled active managers can take advantage of structural inefficiencies in the bond market, including: (1) “clientele effects”, whereby certain investors must focus on bonds with certain ratings or maturities, (2) dislocations between derivatives and physical bonds, which help allow managers to arbitrage differences in pricing on an unleveraged basis, (3) 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, and (4) ETFs, which may use narrowly defined indices, creating arbitrage opportunities on individual securities amidst heightened inflows or outflows.
As a result of these inefficiencies, we believe investors should try to get the most from their fixed income allocation by combining a ‘smart beta’ approach to indexing based on economic footprint with the benefits of an active management approach designed to take advantage of the ample opportunities for generating alpha in the bond market.
All investing involves a tradeoff between risk and return, but thinking about the index is critical. Smart beta, or an approach to indexing based on economic fundamentals, is gaining traction in the marketplace. This innovative approach to capital allocation offers the potential for a better risk/return profile and may enhance returns in portfolios that are oriented to more backward-looking approaches to capital allocation, such as those based on stock prices and historical debt issuance.
Whether investors pursue a pure 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.