04 August 2022
Christopher J Wigley suggests a new type of responsible investment fund that could replace the ETF
Financial markets often reference indices. However, examining the concept of indices reveals them to be a little absurd.
For example, an equity index will often rank the largest companies by capitalisation. However, does this really serve the investor's purpose? Similarly – and perhaps more strangely – a bond index may rank bonds by issue size.
The positives of this approach include a suggestion that these are the strongest entities by financial strength, and additionally, by virtue of their size, perhaps these entities help in providing some degree of liquidity.
However, just because these issues are more liquid does not mean they are better investments. Additionally, asset owners will often expect asset managers to at least equal or outperform 'the market'.
These indices are taken to be 'the market', but are they really the market?
Indices have rules and many issues are included in indices and many excluded. For example, issues which are of relatively small size are often excluded.
If every possible market security were included in a comprehensive index, then to be precise the index would have to be revised for old and new issues daily, which would be impractical. Consequently, it is impossible for any index to represent 'the market'.
As a result, indices fail on at least two counts. They represent little value to investors in terms of purpose, and also they do not represent the market.
Perhaps investors should take a different approach. Perhaps they should prioritise what they actually want.
Problem of ETFs
Because many asset managers struggle to outperform an index, some asset owners opt for a passive Exchange-Traded Fund (ETF).
The scope for underperforming an index is less here. However, in responsible investment, there are problems here too, even with responsible investment indices.
Firstly, if a controversy develops with an issuer in an index, then the investor cannot immediately divest that particular issue in the index, as they would in active management. Although engagement is an option, often for that investment (ETF) to continue to be eligible and held, the asset owner must wait for the index provider to exclude that particular controversial issuer.
Secondly, an asset owner has no control over the constituents of an index fund. An asset owner may object to certain holdings on ethical or ESG grounds, etc.
Thirdly, as the investment flows through to the index and then to the security issuer, then unless the ultimate investment is a 'use of proceeds bond', the investor has no control over where their money actually goes.
Problem of active management
Of course, the asset owner may take the option of active management, and so the asset owner has more control over invested issuers.
However, with active management there is always the risk the portfolio manager makes bets, which may not work out. Management fees in active funds can be quite high. Consequently, to cover the cost of the fees, some asset managers feel obliged to make big bets to outperform the index. This may be in terms of duration, allocation, etc, often based on a macro view of inflation, growth prospects, etc. Statistically, most active asset managers underperform their indices. So, there is a performance issue as well as a cost issue.
It is worth taking a closer look at cost.
For argument's sake, it is possible to propose that an active fund may cost 35 basis points (bps) a year, while a passive fund may cost 15 bps a year. So, the passive fund costs less because the portfolio manager is not expected to make any bets.
However, both types of fund have an internal cost which they pass on to the investor, and this is part of the absurdity. Because both types of fund are conscious of the performance of an index – which we know is not really the market – and trying to equal or outperform that index, then they rebalance funds as the index rebalances.
Indices rebalance normally monthly, as for example, bond issues approach maturity and are excluded or new bond issues become eligible for investment and are included.
This can have a profound effect on an index. For example, with a Green Bond Index, a new Green Bond from a sovereign may become the largest issue in an index and if it has a long maturity, it can significantly lengthen the duration of the index.
Rebalancing can affect indices in at least four ways. Firstly, it can affect the allocations within an index – for example, sub classes such as governments versus corporates, credit ratings such as BBB versus single A rated, industry sectors such as financials versus utilities, etc.
Secondly, rebalancing may affect the maturity allocations – for example, the percentage allocation to 0-5 years or 30 years plus, etc.
Thirdly, rebalancing may affect the overall duration of the index, either longer or shorter.
Finally, rebalancing will affect the quality or constituents of an index.
Consequently, portfolio managers who do not want to underperform are moved to change allocations, duration, etc or buy the issue, even though it might not make much investment sense. Additionally, all this has a cost.
There is an alternative or new structure that is possible. It has already been established that it is impossible to quantify 'market' performance because it is impossible to establish precisely what 'the market' is.
So, an alternative is to establish precisely what clients want. An Investment Policy established three months before the start of the year could establish the required duration.
Additionally, the required allocations to maturities, sectors, etc could be pre-set too. This may reflect a preference of the asset owner and it may be based on, for example, ten year index averages for the allocations, durations, etc.
Being based on ten year averages means that the fund will not be a million miles away from a current type of index anyway.
Euro Sustainable Corporate Bond Fund
|Based on 10 year averages to 2020|
The allocations, durations, etc pre-set three months before the start of the year could be parameter mid points set within ranges, allowing some flexibility for portfolio managers, so discouraging the need to frequently adjust a fund's profile.
This means that monthly rebalancing of funds will not be necessary and this could represent a significant saving in costs. This could represent a significant saving versus both active and passive funds. Additionally, there would be no risk of poor execution of rebalancing.
There is another point also. Responsible Investors tend to be long-term investors, and so not only would this new structure of index be low cost, it would be long term also. That is, investments would be constant and not subject to short term vicissitudes of financial markets or indices.
Another reason why this structure lends itself to Responsible Investment is its facility for security selection. More than conventional portfolio management techniques such as duration management, allocation management, etc, it is security selection which determines the 'Responsible' nature of a fund.
It is possible for a portfolio manager of this new type of fund to keep the fund fresh by switching out of expensive issues in the secondary market and buying new issues where there is a concession and credit spread pick up.
Similarly, it is possible for a portfolio manager to add value by completing anomaly switches by selling expensive issues in the secondary market – a trader may, for example, be short a security that he or she has to deliver to a market counterparty within a limited time period , and so is willing to pay a premium to the portfolio manager – and then the portfolio manager can buy other secondary market issues which provide relative value.
This security selection would be a constant process of capital preservation and conservation, versus potential losses from macro bets. Losses are theoretically possible from security selection but they can be limited by diversification. Security selection would also be a process of constantly improving and evolving the portfolio. More specifically, it would be a process of reducing exposure to companies moving towards extinction and increasing exposure to sustainable companies adapting to new trends and moving to relative dominance.
There would not be an additional cost for security selection, as it can be paid for by the money saved by eliminating monthly rebalancing. Further, a portfolio manager would be conducting security selection across all funds, so there should not be a significant increase in costs.
Finally, when a portfolio manager doesn't need to constantly adjust funds to macro changes or rebalancing, then it frees the portfolio manager to concentrate on other Responsible Investment tasks, for example, Engagement.
Not buy and maintain
Some might argue that this new type of fund is similar to 'buy and maintain' funds. However, buy and maintain funds tend to be driven by corporate fundamentals.
Bonds may be bought and held to maturity unless they are considered likely to default. Additionally, there is often no limit to the number of securities in a portfolio – which could number 300-400. Securities are just bought and 'maintained', not actively managed.
This new type of fund would have issues consisting of about 100 for diversification. Additionally, it would not be solely driven by corporate fundamentals. It would also provide more focus by using portfolio construction considerations including the pre-set allocations to sectors, maturities, etc
There is also flexibility in fund types. A Responsible Investment asset owner may choose to prioritise high ESG constituents, or high impact constituents. Similarly, an asset owner could just select a passive fund which follows the pre-set criteria.
Additionally, the fund could be a 'transition focused' fund. Further, there is flexibility to select a fund which also aims to outperform an index average with a different investment policy of pre-set criteria.
This approach may establish more meaningful indices and funds.
Security selection would be Responsible Investment active management for a cost of no more than the rebalancing cost.
Additionally, this type of fund would avoid Responsible Investment negatives of ETFs in terms of investor choice (or preference against certain issues).
Fees could be in the region of 15 bps per annum, and so low cost and no more than ETFs.
The comprehensive 'market' cannot be known, and so asset managers can never outperform 'the market'. Consequently, it is perhaps better to design funds with clear objectives, and set parameters around what clients want, using stable pre-set annual criteria – which might deliver higher performance or other targeted outcome – and with value added by Responsible Investment security selection.