Credit risk and index funds - why cap-weighted indices still have a role to play in uncertain times

21 December 2012 | Topical insights


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With the European credit crisis still unresolved, institutional and private investors alike are looking with increasing discomfort at passive funds that seem to track their index stoically, as if the world hadn't changed. Traditional cap-weighted indices contain all of the bonds traded in a particular market. Because the market now considers several European issuers as weaker, some investors have switched to different benchmarks that exclude these securities. They may be wrong.

A simple solution?

The new fear of sovereign default has largely benefited semi-passive funds with alternative weightings, such as smart beta funds that track their own indices, as well as active funds. Both claim to get around the sovereign debt problem by excluding or underweighting certain securities or countries. They do so by using a variety of indicators, such as GDP or landmass, to determine allocations. Crucially, they usually don't rely on the market capitalisation and therefore underweight countries with large amounts of debt outstanding (relative to GDP). Intuitively, this approach may make sense, but benchmark tailoring has its own risks that investors should be aware of. Meanwhile, market-cap weighted indices may not be as static as they appear.

Many of today's smart beta funds owe their existence either to the financial crisis of 2007-08 or to the ongoing Euro crisis. They were designed in response to the unfolding events, not in anticipation of them. As such they represent solutions to the problems of the past. Unfortunately, in financial markets, the past is not always a good indicator of future performance.

Debt isn't everything

Excluding certain highly indebted countries to prevent losses may sound like a reasonable way of controlling risk at first. But even in recent history, countries have defaulted for different reasons, not just because of the size of their debt. For example, both Russia in 1999 and Argentina in 2003 defaulted despite relatively low levels of national debt. In both cases, large swings in the countries' exchange rates to the US Dollar caused the default, a factor that smart beta funds may not take into account. No one can predict what will trigger the next sovereign debt crisis or when it will occur. It is questionable whether a strategy addressing yesterday's problems will protect investors next time around.

Unwanted side effects

using alternative weighting schemes can cause investors another problem. Because they typically rely on a set of rather static rules, their weightings may not change as the markets move. Such funds may therefore end up overweighting the very securities they were designed to underweight (relative to the market). This unwanted result is not merely theoretical. With some alternative weighting strategies, this is exactly what happened, and investors ended up with more of what they didn't want rather than less.

The advantage of cap-weighted indices

This is where the strengths of cap-weighted indices really come into play. As bonds trade in the market, their value changes and so does their capitalisation weight. As a result, funds tracking cap-weighted indices reflect the consensus view of the market on any bond's value at a given time. The market weight takes into account both optimistic and pessimistic views of the future as well as any valuation criteria used by market participants.
Investors should bear in mind that a downgrade or default by any European country is a risk, not a certainty. Therefore, if certain European bonds look riskier than before, their market price will reflect that. Deliberately underweighting or excluding these securities represents an active bet against the market consensus that may or may not pay off.

Depending on their risk tolerance and long-term financial goals, investors may have to reconsider their asset allocation and adjust their exposure to certain markets. But rotating in and out of particular securities and trying to time the market to increase returns or decrease risk might have the opposite effect. The European debt crisis may have changed the perception of risk inherent in sovereign bonds, but it has certainly not taken away the benefits of broad diversification. That's why a fund representing the consensus market view may not be such a bad idea after all.

The value of investments may rise or fall and investors might not get back the amount originally invested.


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