Market indices are inherently inefficient. That can pose a problem for fund managers who rely too much on them as performance and risk benchmarks, explains Josh Lohmeier, head of North American investment grade credit at Aviva Investors.
As investment managers, we are in the business of helping clients meet specific investment objectives by delivering expected outcomes or rates of return. Those outcomes are not necessarily tied to a benchmark, but benchmarks are useful as a yardstick to measure how effective managers are.
One way investors and managers use benchmarks to gauge performance is by measuring tracking error, or how much a portfolio’s return deviates from its benchmark return over a specific period. Too often, tracking error is viewed as the level of risk a manager takes in pursuit of the portfolio’s stated investment objectives. However, what it really measures is the portfolio’s deviation from the benchmark allocations: this may mean the portfolio has more or less risk than the benchmark.
Tracking error can be useful to assess how much and where active investment managers’ portfolios deviate from benchmark allocations. But some managers rely too much on tracking error to the extent it becomes more of a crutch; they let an outside index dictate many portfolio decisions out of fear of deviating too far from benchmark returns, rather than turning to their own best ideas and investing with conviction.
Tracking error can be a helpful gut-check of portfolio deviations relative to a chosen benchmark, but it is important to be aware of its limitations. Credit managers should develop other tools for measuring and allocating risk in the portfolio construction process, ones that are less reliant on tracking error and more focused on portfolio volatility.
Missing the mark
One problem credit managers face in benchmarking is the inefficiency of bond indices, due primarily to the size and structure of fixed income markets. Looking at US markets in particular; bonds are largely traded over-the-counter, which can make price discovery difficult and lead to wide variability in price changes. Liquidity can also be a concern, especially in the recent period of low interest rates. Bond investors have not been too concerned with liquidity during the quantitative-easing years, with major central banks conducting massive purchase programmes in specific areas of the market. However, once the Federal Reserve and other central banks curtail their indiscriminate bond-buying sprees, the inefficiencies of bond indices could become more apparent.
Bond indices also have a weighting problem. With equity indices that are weighted by market capitalization, such as the S&P 500, size is largely determined by market prices with the best-performing companies often providing the most influence on the index. With bond indices, size is related to the amount of the outstanding debt; the biggest components in the index are issuers who are heavily indebted or highly leveraged. This may not necessarily be a problem; many of these firms may be well managed and have strong balance sheets, especially in the investment-grade market. But more debt is generally associated with more risk, so issue size in bond indices can create inefficiency.
The inefficiencies of bond indices may pose a thorny problem for credit managers who focus too much on tracking error. If benchmarks are inefficient, deviating from them should in theory be a good thing, resulting in either lower risk or better returns. However, the opposite is often true — managers try to stay close to their chosen benchmark and variations from this are viewed as taking on extra risk, with little focus on the total beta (or volatility) in the portfolio relative to the benchmark.
Tracking error: The good and the bad
Let’s consider two ways credit managers use tracking error, to both good and bad effect. First, a manager who is too benchmark-focused and wants to reduce tracking error may hold a security they have a negative outlook on just because it represents a large part of the portfolio’s benchmark. Perhaps the manager shows disfavour by underweighting the issue in the portfolio, but they still own the security even if it falls outside of their best ideas. In this case, we would view reducing tracking error as bad; the manager may succeed in lowering their tracking error by sticking closer to their benchmark, but the security may not contribute much of anything to excess returns and could even serve as a drag on overall performance.
Second, let’s look at the flip side, when adding it can be good for portfolio returns. In this example, a manager may avoid an issue where they hold a negative outlook and look for a different opportunity that presents similar levels of risk and volatility. Deviating from the benchmark in this manner would be considered ’taking on risk‘ because it adds tracking error. But if the decision works out as the manager intends — in other words, if avoiding the disfavoured security successfully minimises losses and favouring a better idea contributes positively to performance — the result should be better risk-adjusted returns, even if tracking error is higher.
Ultimately, clients are better served by managers who develop robust risk allocation processes, construct portfolios thoughtfully with their best ideas, and invest with conviction.
Building a better benchmark
Every investment manager, in credit or other asset classes, follows a process for building portfolios and allocating risk. When reviewing these managers and their different processes, investors should ask each an important question: does your process deliver higher returns for less risk or the same returns for a lower risk profile than stated benchmarks? This is the definition of ’alpha‘. Put another way, if a manager only manages to outperform when markets rally, there is a much higher probability they are merely adding beta to achieve excess returns.
An ideal portfolio construction process would accomplish higher returns for less or similar risk, while providing consistent risk-adjusted returns in all market environments, not just when markets are rallying. Achieving this goal would likely require a more complex approach than the usual ’bottom-up‘ credit review and due-diligence steps. Bottom-up or top-down constructions are not wrong necessarily, but may not be enough to provide excess returns over the course of a full credit market cycle. A more sophisticated approach may uncover sources of additional alpha that a simplistic approach would likely overlook.
Managers need other tools besides tracking error to help them allocate risk
Managers need other tools besides tracking error to help them allocate risk during portfolio construction. If a credit manager can throw off the crutch of tracking error and use it more as a yardstick, they could focus their efforts on seeking better risk-adjusted returns and minimizing volatility.
