ETFs - weight change

Demand for new indices covering fixed income and emerging markets is gathering pace, as investors seek more efficient ways of tracking these asset classes. Helen Fowler looks at a new wave of index developments

Indices are at the heart of every ETF. Yet, up until now, debate has centred mostly on how to follow them, rather than on the actual benchmarks themselves. That is changing, amid growing disquiet over how the benchmarks used to peg these products are calculated, especially in fixed income and emerging markets.

Both investors and providers are increasingly looking at whether they have chosen the right benchmarks as the starting point for passive investments that must hug an index. In the worlds of fixed income and emerging markets, there is demand for new products that will solve the many problems associated with existing benchmarks.

Exchange-traded product provider Source launched its inaugural range of dual-branded fixed income products with investment manager Pimco, the global bond specialist, in January. Pimco already has $2.2bn of ETF assets under management in the US since launching its ETF programme two years ago.

The firms are aiming to launch between 10 and 15 fixed income funds into Europe over the next year that will cater to demand among European investors for “smarter” fixed income ETFs. Some of the products will also be actively managed.

Ted Hood, chief executive of Source, believes there is substantial untapped demand for fixed income because of a shortage of appropriate benchmarks. “Bonds account for more than 50% of the average investment portfolio,” said Hood. “But fixed income ETFs account for a much smaller proportion of total ETF assets.”

Source has already succeeded in almost tripling its assets over the last year, growing them from $2.5bn to $6bn, thanks to the strong performance of its sector-based products. The firm sees expansion into fixed income as a logical next step. “Looking at the fixed income products in the market we realised there was room for improvement,” added Hood.

The partnership aims to create ETFs based on its own indices as well as a range of actively managed products that will address the issues involved with traditional bond investing. “Pimco offers a range of fixed income products, some of them active, others passive, and I wouldn’t be surprised if we follow that path,” said Hood.

Increasing interest

The launch coincides with rising interest in fixed income. ETFs providing exposure to the asset class have more than tripled in size over the last three years, growing from $60bn to more than $200bn, according to BlackRock.

US fixed income ETFs though have been the market’s fastest-growing area, with $31.5bn in inflows over the last year, according to Edhec-Risk Institute. Equities still dominate the ETF universe, making up more than three quarters of all assets. Fixed income products account for just under a fifth of all ETF assets, suggesting there is indeed the room for growth that Hood predicts.

The usual method of constructing a bond index is to give proportional weightings to components based on how much of the index they constitute. The method is known as market capitalisation and the indices are ‘cap-weighted’.

The cap-weighted approach tends to be effective in equities – where it was pioneered – but fares less well in the world of fixed income. The bond universe is very different to equities, featuring different maturities, ratings, coupon schemes and other features. “The typical borrower has hundreds and hundreds of bonds,” said Ted Hood. “Most companies have only one share class.” Unlike equities, the bond universe changes constantly, as issuers borrow and redeem bonds. 

The biggest problem with cap-weighted bond benchmarks is that they give more space to companies or countries who borrow the most. “Cap-weighted indices have a higher weighting to companies or countries with a higher amount of debt,” said Alex Claringbull, co-head of UK fixed income portfolio solutions at BlackRock. They also exacerbate every passive manager’s natural tendency to invest more in bonds that have become overpriced. 

Critics of cap-weighted indices say that although the methodology works well for equity markets, this in not necessarily the case for fixed income. Managers are effectively forced to buy those bonds whose price has already gone up. Another problem is that often an investor will buy the entire tranche of debt issued by a company then hold it to maturity, meaning there is no liquidity in the bond and it can be hard to price.

The GDP factor

Index providers have responded to these concerns by launching alternative versions of their bond benchmarks. One approach is to weight bonds by the economic status of their issuer’s country – an approach that grabbed investors’ attention as the eurozone bond crisis was unfolding last year. 

Barclays Global Investors has launched a new family of bond indices weighted by a country’s GDP, in response to investor demand for better ways to benchmark the fixed income universe. Instead of simply multiplying the number of outstanding bonds by their price, as a traditional market cap-weighted index does, a GDP weighted benchmark measures a bond’s size by the strength of its economy.

Using this approach means investors do not end up with a higher weighting to the more indebted countries, said BlackRock’s Claringbull. He added: “It’s potentially more forward-looking.”

Weighting by GDP places greater focus on developing countries. Barclays notes that 22 emerging market countries account for 15% of global GDP, but form less than 1% of the Barclays Global Aggregate Bond index by market value.

The GDP-weighted methodology used in the Barclays GDP weighted index family leads to a significant underweight in Japan and a correspondingly higher allocation to countries like Brazil, China, India, Russia, Taiwan and other emerging markets.

Clients reportedly remain muted in their enthusiasm for the GDP approach “There’s a lot of talk about GDP-weighted indices,” said BlackRock’s Claringbull. “But to date there has been very little uptake from clients.” iShares, the largest ETF provider in the world, does not offer any ETFs based on the new indices.

However, GDP-weighted indices can bring their own problems. One perhaps unexpected consequence of this approach is that investors end up with high weightings to debt-free emerging markets. That can in turn introduce other difficulties when attempting to buy up large weightings in illiquid and immature markets.

Dow Jones offers one alternative to cap-weighted indices – a corporate bond index that is an equally-weighted basket of 96 recently issued investment grade corporate bonds with laddered maturities. The index intends to measure the return of readily tradable, high-grade US corporate bonds and is priced daily.

There are other solutions to cap-weighted, too. Investors who do not like the composition of a broad index can choose to assemble their investment using different ETFs. Anybody uneasy about exposure to some of Europe’s less stable countries could instead buy an ETF investing only in triple A-rated debt.

Emerging markets have their own problems with benchmarks. The asset class accounts for even more of the ETF universe than bonds. ETFs based on emerging markets have around $238bn in assets, according to BlackRock, and make up around 18% of all the assets held in ETFs – compared to 16% for bonds.

Yet the structure of emerging markets has led investors to question how they can best benchmark them. Often, an emerging market is dominated by a single stock. For example, most China trackers have a lopsided weighting towards the state-controlled megabanks. This approach to index construction leads to stock and sector imbalances and unintended concentrations.

Manooj Mistry, head of db x-trackers UK, which has nearly €10bn in its suite of emerging markets ETFs, said that his firm modified emerging market indices where necessary. The ETF provider does so to ensure its products retain their Undertakings for Collective Investments in Transferable Securities (Ucits) status.

A Ucits-compliant fund must adhere to rules on the proportions allowed in a portfolio. For example, no single company may account for more than 10% of the fund. Where a company accounts for more than 5% the total may not exceed 40%. This is potentially a problem, when a single firm such as Russia’s Gazprom accounts for almost 50% of certain Russian benchmarks. Db x-trackers caps components so they meet Ucits guidelines.

According to Felix Goltz, head of applied research at the Edhec-Risk Institute, the cap-weighted approach is even more of a problem in emerging than developed markets. “In emerging markets the problems with cap-weighted are even more severe. You can see that typically differences in performance are even greater in emerging markets,” said Goltz.

Using a cap-weighted index in emerging markets would have returned just under 13% yearly over the last five years. Swapping that for the FTSE Edhec Risk Efficient benchmark would have produced around four extra percentage points in performance, according to Goltz.

Yet cap-weighting, despite its drawbacks, continues to account for the majority of assets held in ETFs. “You can see the market is dominated by cap-weighted indices,” said Goltz. As more investors venture into fixed income and emerging markets, where the arguments against cap-weighting are even stronger than elsewhere, new benchmarks look set to emerge and gain traction.