Passive index replication or enhanced indexing for corporate bonds?

In recent years, passively managed approaches have become increasingly popular for corporate bonds. A distinction is made between fully passive approaches, which aim to replicate the composition of an index, and so-called enhanced indexing approaches (also known as “passive enhanced”), which have a risk profile that is very similar to that of the index with low tracking errors to the specified benchmark, but allow smaller deviations in order to earn the costs of the approach. 

In this article, we compare the similarities and differences between the two approaches and highlight four arguments that demonstrate the advantage of enhanced indexing over purely passive approaches.

Argument 1: Investors will have tracking error in both approaches

Lack of liquidity prevents exact index replication. For example, a standard global corporate bond index consists of between 16,000 and 19,000 bonds, depending on the provider. Many of these are difficult to buy in the market, and the illiquidity of many securities prevents their purchase for a passive fund. The chart below shows the number of days per year that individual bonds are traded. It is based on the TRACE database, which collects reportable transactions in USD bonds.

The chart shows that many bonds are traded only a few days a year. Liquid trading on many days is the exception rather than the rule. The fact that a bond was often not traded does not necessarily prove that it could not have been traded on one day or another. However, experience shows that there is a positive correlation between transactions executed and tradability.

In addition to a lack of liquidity, there are also issues such as monthly rebalancing, where bonds that are no longer eligible (e.g. after a downgrade to high yield) are removed from the benchmark. The underlying prices often deviate from the prices that can be achieved in the market. This makes the performance of the benchmark an unattainable theoretical scenario from which a replication portfolio deviates to a greater or lesser extent.

This means that even purely passive mandates have to develop a strategy to replicate the benchmark, as many of the bonds in the index are not available for purchase. As a result, even supposedly passive funds will have some tracking error relative to the index. The question of whether to invest in passive or low tracking error approaches does not therefore arise in corporate bond management: all approaches have some tracking error to the benchmark. There is no such thing as passive investing in corporate bonds.

Argument 2: Enhanced index can better optimise the tracking error for implementation costs

Even if it were possible to buy all the securities in the benchmark, it would not make sense to do so. Beyond a certain level of coverage, adding more bonds to the replication portfolio hardly changes the tracking error, while the transaction costs associated with adding more bonds, which become less liquid, increase. The following diagram illustrates the trade-off between minimising tracking error and minimising costs.

Since transaction costs increase disproportionately with higher replication, but variance risks increase disproportionately with low replication, total costs, measured as the sum of variance risk and transaction costs, are U-shaped and a minimum can be identified. Enhanced indexing approaches can operate in this sweet spot, provided that the resulting ex-ante tracking error is within the acceptable range. Passive approaches that only aim to minimise tracking error often deviate from this sweet spot.

Argument 3: Active decisions avoid downgrades

Passive approaches do not make active investment decisions on riskier issuers. Consequently, on average, they should have a similar number of downgrades from investment grade to high yield, with issuers subsequently removed from the investable universe. The chart below shows the long-term transition probabilities between rating categories. It can therefore be used to calculate a long-term average.

The chart shows that 10.5% of the bonds in a standard corporate bond index are rated Baa3/BBB-. 1.6% have the worst rating Ba1/BB+. There are no bonds below this. After one year, the proportion of bonds whose worst rating is below Baa3/BBB- has already risen to 2.6 %, after two years to 3.4 % and after five years to 5.5 %. It must also be expected that a small proportion of bonds will default.

Such downgrades are usually penalised with significant price declines. Investors try to avoid the affected bonds or sell them before they are downgraded. Enhanced indexing approaches have this ability and can add value by deviating from the benchmark in the riskiest names thus avoiding the operational challenges of holding troubled issuers. They can also proactively sell the positions.

Argument 4: Enhanced index strategies can recoup costs with comparable tracking error, risk profile, diversification and fees

Ideally, a passive fund will match the performance of its benchmark before management costs. This usually leaves the investor with a small negative net active return due to the management fee. Through small deviations from the benchmark, security selection, avoidance of the largest risks and cost-effective replication of the index characteristics, enhanced indexing approaches have the potential to generate an active excess return and thus to earn the management costs for the investor. Tracking error is low and diversification is high, while the risk profile of the investment is close to that of the index and the management fee is closer to passive than active approaches. This makes enhanced indexing an attractive alternative to passive approaches.

Conclusion

The growing trend towards more passive forms of investment in corporate bond management raises the question for investors in this area of how to structure their passive investments. As there is no such thing as purely passive management in the credit space due to the illiquidity of much of the investment universe, investors must determine the maximum tracking error they are willing to tolerate. Enhanced indexing approaches allow investors to operate cost-effectively within this predetermined range, reasonably avoiding the largest cost pools and risks of the benchmark and attempting to earn the management costs. At the same time, they can ultimately deliver the benchmark performance plus a few extra basis points to the investor. All this with the same risk as the benchmark. This offers investors an attractive alternative to traditional passive approaches.

To find out how Quoniam implements advanced indexing to enable investors to invest in corporate bonds in a cost-effective and risk-controlled manner, read the second part of this article, coming soon.