The ETP-Provider Source has published an update that highlight the improved performance of GDP weighting compared to the traditional capitalization-weighting within the Fixed Income space.
A general lesson learned from the development of the government bond market in recent years is that risk also needs to be diversified widely in this part of the market. The use of market value weighting means that the states with the largest debts are given the greatest weight in the benchmark. Strong increase in public borrowing in many countries, and increased uncertainty about certain states’ ability to service their debts, underline the need to reconsider the principles governing the proportions of different government bonds in the benchmark.
Below illustration highlight an example of the performance difference between the two index weighting methodologies, over a three and seven year period.
It is evident that while volatility appear to be about equal, GDP-Weighting appears to out perform over both time periods, performance difference having increased recently.
The underlying PIMCO Index, produces a European government bond index that has higher weights for less indebted countries and lower weights for highly indebted countries. Therefore, the weights to peripheral countries are lower than in traditional market capitalization-weighted indexes.
Advantages of GDP Weighting
GLADI weights index components based on gross domestic product (GDP) as an alternative to the market capitalization weights used by most existing fixed income indices. GDP weighting offers a number of relative benefits:
1. Forward-Looking. Fundamental transformations in global capital markets are reshaping the financial landscape for retail and institutional investors. Market capitalization-weighted indices fail to capture these changes because they are inherently backward-looking, reflecting past patterns of debt issuance. Since rapid economic growth tends to precede the liberalization and deepening of capital markets, GLADI’s GDP weighting is designed to capture the opportunities that exist in the world’s most dynamic economies. By embedding a concept of where capital markets will be in the future – rather than where they have been in the past – GLADI helps investors position their portfolios to reap potential first-mover benefits.
2. Counter-Cyclical Rebalancing. A well-known disadvantage of market capitalization-weighted indices is that they assign progressively greater weight to securities as they go up in price, exactly the opposite of the investment maxim to “buy low, sell high.” GLADI not only avoids this pitfall of market capitalization weighting, but also has the potential to benefit from counter-cyclical rebalancing, since bond prices tend to move inversely to GDP growth over the business cycle (rising in price as economic growth slows, and falling as economic growth accelerates), as illustrated below.
3. Avoiding Excessive Borrowers. Market capitalization-weighted indices have traditionally assigned greater weight to large-scale issuers, even though the credit quality of those issuers may be eventually compromised by their debt load. GLADI’s GDP-weighted approach avoids over-allocating to excessive borrowers.
The construction of GLADI follows three steps: (1) regional weights are assigned based upon the relative GDP shares of the respective major regions in the global economy, (2) factor/instrument category weights are identified based upon the primary sources of fixed-income risk/return available to global investors within each region, and (3) security selection within each sub-index is determined by a series of eligibility tests and a market profile process designed to maximize the ability to replicate and invest in the index components.
As discussed above, market capitalization weighting has the disadvantage of increasing the weight of securities as they become more expensive. In addition, market capitalization-weighted global indices tend to be dominated by government bonds because of their large historical issuance, despite the fact that many bond managers tend to use other instruments, such as interest rate swaps, as a substitute for the interest rate duration that comes from government securities.
To avoid these issues, GLADI takes a different approach, employing a proportional weighting system based on the key sources of fixed-income risk and return. Of particular importance are: (1) interest rate duration, reflecting the sensitivity of bond prices to changes in nominal and real yields; (2) credit premiums, reflecting the higher yields available on securities with credit risk; and (3) securitized instrument premiums, reflecting embedded pre-payment options and other premiums associated with mortgage-backed securities. In the absence of a robust theoretical or empirical rationale for departing from a parsimonious equal weighting of each of these factors, this is adopted as the preferred weighting scheme.
The universe of potential securities is defined by a series of eligibility criteria. In order to preserve reliability and investability, the number of securities selected within each market is limited, depending on the size of the market and liquidity considerations. When the actual number of securities in the market exceeds the limit, a market profile process is applied to select the securities that will be included in the index. The market profile process refines the universe of eligible securities to identify the most representative and liquid securities, producing an index that is replicable and investable.
There are four eligibility criteria that define the universe of instruments:
- Credit Quality. Eligible instruments must be investment grade (BBB- or higher). The average rating from Moody’s, S&P and Fitch is considered when available. Instruments downgraded to below investment grade are removed from the index upon monthly reconstitution.
- Instrument Type. Outside of derivatives instruments, only fixed-rate, non-callable (except for mortgage-backed securities) bullet bonds or sinking funds issued by developed and emerging governments, corporations and securitization entities are eligible.
- Remaining Maturity. All emerging market, inflation-linked, corporate and securitized bonds must have at least 12 months remaining until maturity. Securities with maturities of less than 12 months upon monthly reconstitution are excluded from the index.
Minimum Par Amount Outstanding. Eligible instruments must have a current par amount outstanding greater than or equal to a minimum amount that differs by instrument and is currency specific. Minimum par for inflation-protected bonds is 2 billion USD or the approximate foreign currency equivalent. For corporate bonds the minimum is 500 million USD, 100 million GBP or 300 million CAD, EUR, AUD or CHF. Securitized bonds must have minimum par of 1 billion CAD or EUR, 100 million GBP, 300 million CHF, 2 billion SEK or 3 billion DKK. For emerging markets, the minimum for external bonds is 500 million USD or EUR, while local bonds must have a minimum local currency equivalent of 100 million USD.