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Nov 09

Beating the Inefficient Fixed Interest Benchmark

Its widely agreed that size-weighted fixed interest benchmarks are a poor construct when it comes to creating the optimal fixed interest portfolio. The logic from most people goes along the lines of “why would I accept the index as optimal and overweight my portfolio with the biggest issuers because they are the riskiest and more likely to default than the smaller issuers” and there is probably some truth to that.

The amazing thing with fixed interest benchmarks is that an incredible proportion of active managers fail to outperform this so-called inefficient benchmark. According to the latest Australian SPIVA report, 92% of Australian bond funds that were around 5 years ago failed to outperform the S&P/ASX Australian Fixed Interest Index, and given that includes the GFC period perhaps we should be fair and look at more recent times…unfortunately its even worse over the last 12 months…100% failed to outperform!!!…please note performance is through to June 2012.

So active managers struggle to beat fixed interest benchmarks so perhaps they’re not so inefficient after all, and to be honest, dare I say it, I tend to agree. I believe that at any one point in time, the market is fairly accurate at assessing the true risk/or appropriate yield of each index participant…not always but most of the time. The challenge for active fixed interest managers is not to underweight those securities that have the largest index weights…it is to invest in those securities that will outperform the rest of the market and avoid those that underperform. To do this active managers need to predict the change in risk of a company or semi-government or government debt security and this is where its difficult…predicting change in risk is tough. So whilst intuitively the largest index participants may carry the most risk because they have the most debt…if that debt is priced accurately then it doesn’t really matter because a premium is built into the price and the investor may benefit from that…the key is to avoid those that aren’t priced accurately and buy those that are. So, for example, given Italy has a very large index weight in global fixed interest benchmarks, does that mean its bad? Definitely not. Active managers who failed to hold Italian bonds when yields came down over the past few months have missed out on some decent capital growth and vice versa if they held Italian debt whilst the yields rose to their great than 6% levels in the preceding months. Predicting change in risk (after fees) is not easy and why I believe active managers fail to outperform these so-called inefficient benchmarks.

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