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Bond index: why the weighting methodology matters?

30.09.2013Cedric Mbeng Mezui, Christian Schedling

Indices have been around for centuries to measure performance and change. The first conceptual index was created by Rice Vaughan in 1675 in his book 'A Discourse of Coin and Coinage' when he compared price levels over time (Chance, 1966). In 1707, William Fleetwood published the first price index in the Chronicon Preciosum to show the change of prices over time (Chance, 1966). The first investment index was calculated when, according to McHugh and Wood (2006), Charles Henry Dow "invented" the concept of following parts of the stock market separately as indices, in 1896. As editor of the Wall Street Journal, he believed that "averages" or indices can be an indicator of business conditions. Charles Dow set up the rail index (now called the Trannies) and the Industrial index.

Many initiatives have been launched to construct weighted benchmark indexes to reproduce the underlying performance of emerging and African domestic bond markets, such as Ecobank Middle Africa Bond Index, JP Morgan EM Index, JP Morgan Next Generation markets index, Citi's WGBI, the GBI-EM Index, etc. They all look at a clear and transparent set of inclusion rules for selecting countries and instruments eligible for the index. This is well aligned with the African Development Bank agenda to actively contribute to the development of sustainable domestic debt markets in Africa through the creation of the African Domestic Bond Fund (ADBF) which will be invested in local currency denominated sovereign and state guaranteed sub-sovereign bonds.

An index is defined as a selection of securities with the same or similar risk features chosen to represent a particular market. Investors use indices to measure the performance (i.e. beta) in those particular markets. However, the debt crises in Europe for both sovereign and corporate bonds have steered some investors to query the advantages of indexes constructed based on the traditional technique of market-capitalization. For some index developers, cap-weighted fixed income indices are considered to provide suboptimal portfolio allocations and impair performance.

Market capitalization-weighted fixed income indexes

For an index to measure market performance it should be fully inclusive. For practical purposes it is impossible to measure the beta of every single instrument in the market. Therefore a representative sub-set is selected based on a transparent, replicable, relevant and objective rules set. For practitioners, a cap-weighted index reveals the relative value of debt securities as determined by market participants, without altering the market's relative structure. The main variable defining a security's weight in a cap-weighted index is its price (Bennyhoff, 2012). In an open economy, the market price of a security reveals every market participant's information, views, and anticipations about the value of that bond. Additionally, a liquid market makes sure that the price of any given security reflects the consensus appraisal of its intrinsic value, accounting for the projected risk and return from every investor's valuation practice. The cap-weighted index is the benchmark for most of fixed income investors. It holds its constituents in proportion to the size of their issuance. A benefit of the cap weighted index methodology is the easiness to track because it changes automatically as the price of underlying bonds change.

However, for many index developers (Arnott, Hsu, Li and Shepherd, 2010), the optimality of cap-weighted indexes as investment options hinge on the hypothesis of perfectly efficient capital markets and rational investors with mean-variance utility preferences. In the real-life, market mispricing is reflected in the market prices. As the rationale is that a cap-weighted portfolio bases its component weights on prices and that is a correlation between pricing errors and portfolio weights that leads to suboptimal distribution and performance. In brief, should an investor focus on elements, such as GDP, landmass, population, energy consumption, or an investor focus more on issues such as political risk, inflation, exchange rate policy, external debt... Practitioners consider that market capitalization captures all the potential factors that investors collectively analyze to fix a bond's price.

Fundamentally-weighted fixed income indices

In the weighting methodology constructed using fundamental variables (GDP, landmass, population, energy consumption); the weighting is based on the issuer's aptitude to pay its debt rather than on the quantity of debt outstanding. This methodology suggests that countries with better fundamentals get greater weights than those with weaker fundamentals. The use of these proxies lies in the fact that these four elements symbolize a country's capital, labor force, natural resources and technological sophistication. They play a catalytic role as primary inputs to an economy's growth. It seems that the fundamentally weighted portfolios outperform both cap-weighted portfolio benchmarks (Shepherd, 2012) and weighting according to fundamentals has led to a major enhancement to the Sharpe ratio.

The weighting of these indexes is based on several macroeconomic elements. Nonetheless, indebtedness is not the sole factor in assessing sovereign risk. For instance, if a country crowds in the market with new bond issues to the extent that investors start having doubts about the repayment capabilities of the sovereign entity, prices of outstanding issues may drop in anticipation of a lower credit value of the debt, and consequently the country's market capitalization will fall. This is well aligned with Reinhart (2010) analysis that showed that there is a certain level of debt that governments can reach before a slowdown in economic growth begins.

What needs to be considered for decision?

A cap-weighted fixed income index leads to suboptimal allocations and performance (or beta). On the contrary, a fundamentally weighted fixed income index yields superior performance over time. However, for practitioners the best index is certainly not one that offers the highest return during a given period of time but the one that most precisely measures the risk-reward features of the collective capital invested within the market being tracked.

Market capitalization offers advantages when considering the entire market and fundamentally weighted indices represent the segment of the universe that has the higher return potential. Both approaches have pros and cons. whereas in 'normal' times market cap weighted indices are less volatile in its composition and therefore cheaper to track, the fundamentally weighted indices have advantages in times of recessions and market turmoil. Maybe a combination of both would be the ideal solution - so called 'collared' schemes. The advantage would be moderate turnover and full scalability in times of efficient markets and diversification and less dependency on stressed sectors of the markets in turmoil.

Cedric Mbeng Mezui: Senior Financial Economist, African Development Bank

Christian Schedling: Managing Partner at Concerto

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05.10.2013 11:09 - Asongu Simplice
Congrats and concerns

Congrats to Mezui & Schedling for rethinking the issue at this momentous time. I enjoyed the piece but also expected the following points to be highlighted along the lines: (1) how the piece reflects the recent global financial crisis; (2) how the weighting methodology has played-out in the European Sovereign debt crisis and; (3) lessons for African financial markets. Perhaps another piece incorporating the three highlighted concerns would deviate from the sound theoretical underpinnings and provide more policy implications. Best, Simplice

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