Some prominent institutional bond investors are shifting their focus from traditional benchmark indices,which weight countries’ debt issues by market capitalization, towardGDP-weighted indices. PIMCO, one of the world’s largest fixed-income investmentfirms, and the Government Pension Fund of Norway, one of the largestsovereign wealth funds, have both recently made moves in this direction. Butthere is a risk that some investors could lose sight of the purposes of abenchmark index.
The benchmark exists to represent the views of the medianinvestor. For many investors – both those who recognize their relative lack ofsophistication and those who don’t – going with the benchmark is a goodguideline. This is an implication of the efficient markets hypothesis (EMH),for example.
To be sure, EMH theorists are often too quick to discountthe possibility of beating the benchmark: It should not have been so hard tofigure out during the 2003-2007 credit-fed boom that countries with highforeign-denominated debt, particularly in Europe, were not paying asufficiently high return to compensate for risk. Or, to take another (harder) call,some of these same countries’ deeply discounted bonds, after heavy markdowns, would have been good buys in early 2012.
Nonetheless, most investors do better with a more passiveinvestment strategy, especially given high management fees and excessiveturnover for actively managed funds. A benchmark index gives that option tothose who do not think that they can systematically beat the median investor,and provides an objective standard by which investors can judge the performanceof active portfolio managers who claim that they can. Moreover, the sameweights used in the index can be used to compute an average interest rate orsovereign spread in the market, which can, in turn, serve as an indicator ofinvestors’ appetite for risk.
Finally, a benchmark index helps active investors to devisea deliberate strategy to depart from the median investor’s view when theybelieve that view to be mistaken. They may think that the median investor isunderestimating risk in general or underestimating the downsidein countries that have some particular characteristic. For example, they mayconclude that a country has too much short-term debt, foreign-currency debt, orbank debt, or inadequate reserves or national saving.
For each of these purposes that a benchmark index serves, thecorrect way to weight different countries is by marketcapitalization, not by GDP. The keeper of the index must judge whichcountries and bonds are in “the market” – that is, are fully investable; butthat is true regardless of how countries are weighted.
The logic behind the move away from traditional bond-marketindices is that, by definition, they give a lot of weight to high-debtcountries, some of which may be over-indebted and at risk of default. At first,the logic seems unassailable. But, in theory, if the market is functioningwell, it should already have factored in highdebt levels: such countries should pay higher interest rates to compensate forthe incremental risk, unless there is some special reason to think that theycan service their debt easily.
An investor who believes that countries with high debt/GDPratios are riskier than the median investor realizes is more likely to thinkabout his or her strategy clearly if it is explicitly framed in terms of factoring in debt/GDP, rather than framed as switchingfrom a market-cap index to a GDP-weighted index. Furthermore, how the strategyis framed may help investors to recognize that they might want to modify it(for example, if a country’s debt has an unusually short or long maturity structure).
To be sure, default risk among some heavily indebtedcountries, like Greece, turned out to be higher than expected. But there isalways a danger of fighting the last war. Many major middle-income countrieshave paid down much of their debt over the last decade, attaining indebtednessratios far below those of advanced economies.
That point is worthy of closer consideration than it hasreceived. As the chart below shows, major emerging markets have relatively lowdebts (the first bar for each country) relative to GDP (the second bar).Russia’s sovereign debt, for example, is now below 7% of GDP.
As a result, the supply of these countries’ bonds islimited. If global investors switch from market-cap-weighted to GDP-weightedinvesting, high demand for such countries’ bonds may drive their interest ratesto unnaturally low levels, setting off new credit-fed boom-bust cycles in theireconomies.
Moreover, many emerging-market countries have paid down debt denominated in dollars or other foreigncurrencies, while continuing to borrow in their local currencies. Relativelylarge countries, such as Thailand, Malaysia, Brazil, and South Africa, havelittle dollar-denominated debt left – 3% of GDP or less (the dark bottom ofeach first bar). If an international bond benchmark is to be limited todollar-denominated debt, GDP weights could imply a severe imbalance betweeninvestor demand for these countries’ bonds and the small supplies available.
Accordingly, local-currency-denominated debt must beincluded in the benchmarks. But, in that case, a portfolio reallocation awayfrom traditional benchmark indices such as the Emerging Markets Bond Indexwould imply a big shift from simple credit risk toward currency risk. True,emerging-market economies’ ability to attract investment in their localcurrencies represents an important strengthening of the global financial system(relative to the currency mismatch and balance-sheet vulnerabilities of the1990’s). Nevertheless, investors who switch from one “benchmark” to the otherneed to be aware of the extent to which the reduction in default risk comes atthe expense of heightened exposure to currency risk.
In short, it is not crazy for an investor to depart from amarket-cap-weighted benchmark by putting more weight on countries with lowdebt/GDP ratios and less weight on high debt/GDP countries. But theGDP-weighted index should not be mistaken for a neutral benchmark.