The EconomistFebruary 29th 2020 Finance & economics 572
Buttonwood Benchmark blues
I
magine a worldin which the stock-
market has only two constituents:
Gurgle, a firm that has risen quickly, and
Genial Motors, a mature company. Both
have 100m of shares outstanding, each
worth $1. That gives the market a value of
$200m. Further imagine that there are
two investors of equal size in the market.
Both own the same no-cost index fund.
Each has wealth of $100m, split between
Gurgle and Genial stock.
After a year Gurgle triples in value to
$3 a share, while Genial stays at $1. The
market has doubled to $400m. Three-
quarters of its value is in Gurgle stock.
Both investors still hold 50m shares of
each firm. Their total holdings are now
worth $200m each: $150m-worth of
Gurgle; $50m of Genial. They have shared
in the market’s surge. This is a quality of
passive investment in an index weighted
by value. If some stocks soar in price, you
share proportionately in their success.
But say our investors were active
rather than passive, with one holding
100m shares of Gurgle and the other
100m of Genial. The Gurgle investor
triples his wealth; the Genial investor’s
wealth is unchanged. Simple maths
mean that if one active investor beats the
index, another must be beaten by it. And
since active equity managers have higher
fees than passive ones, active investing is
on average a losing game in real life. Few
beat the index consistently. But there is a
twist. This does not hold for active bond
investors. Most beat the index. There is a
kink in the logic of index investing that
active bond investors are able to exploit.
In an idealised version of passive
investing, the universe of securities
remains unchanged from start to finish.
But in the real world the index changes
from time to time. New firms come to the
market via initial public offerings (ipos).Existing firms may issue more stock or
retire some. A few are taken private. And a
benchmark like thes&p500 is not the
whole market, but the largest listed firms
in it. An index fund must occasionally buy
stocks that gain enough mass to qualify for
the index and sell stocks that fall out of it.
So it is not entirely passive. Index funds
must trade—and active investors can trade
ahead of them.
In practice, the turnover in stocks
within equity indices is not large enough
to handicap the passive funds against
active managers.ipos are increasingly
rare. Traffic in and out of indices is light.
Bonds are different. A share is a perpet-
ual security, but bonds have finite lives.
Most of them are quite short: the average
maturity of a Treasury bond is six years. So
there is a lot of movement in and out of a
bond index. An index fund has to trade a
lot just to match the index.
There is simply more scope in bond
markets for winning investors to find
willing losers to bet against. A lot of insti-
tutional investors are constrained in what
kind of bonds they are allowed (or need) tohold. They may be barred from holding
corporate bonds or bonds that are not
rated investment grade. Or they may
need to hold bonds of certain maturities
for regulatory reasons.
The managers of foreign reserves, for
instance, prize liquidity, so hold mostly
short-term bonds. Banks face capital
charges on corporate bonds, so prefer to
hold government bonds. Insurance
companies have long-lived promises to
policyholders to live up to. That creates a
particular thirst for long-dated bonds. In
all, there are a lot of bond-buyers with
goals other than beating the index from
one year to the next. An analysis* by
Jamil Baz, Helen Guo, Ravi Mattu and
James Moore ofpimco, a giant bond-
fund manager, put the proportion of
bonds held by such “non-economic”
players at around half. Active managers
can win by holding maturities that are
less in demand, by tilting towards cor-
porate bonds in the index, or by making
off-index bets on junk bonds—in short
by doing all the things constrained bond-
buyers cannot, or will not, do.
A tragic flaw of bond indices is that
they reward profligacy. Big issuers of
bonds have a bigger weight. So high-debt
Italy looms larger in global bond bench-
marks than thrifty Germany. In equity
indices there is some relationship of
weight in the index to economic suc-
cess—or at least to investor enthusiasm.
Gurgle-like shares enter the index and
make up more of its heft; Genial Motors-
like shares diminish in weight, until
eventually they slip out. Smart active
investors can trade ahead of such entries
and exits. But it is slim pickings. With
bonds, there are more opportunities for
active investors to win.Why active bond investors can beat the index when active equity investors can’t.............................................................
* “Bonds are different” (April 2017)starting,” says Jason Wang, an executive
with a company that sells winter coats.
Like factory managers around the coun-
try, Mr Wang is taking precautions. Work-
ers have their temperatures monitored
throughout the day. They are required to
keep empty seats between them in the can-
teen. Inside the factory, they must always
wear masks. But the pressure is intense.
The government has told companies that if
any of their workers become infected, they
may be forced to shut.
All being well, many analysts think that
China’s businesses will be back to full ca-pacity by the end of March. Economists at
big banks forecast that this resumption
could allow first-quarter growth to reach
about 4%, year on year. That would be the
weakest since quarterly records began, but
anything above zero will inevitably raise
questions about the credibility of the data.
The risks are also changing as the virus hits
other countries. China now faces the pros-
pect of much weaker global demand and
the danger that the epidemic, controlled
within its borders, re-enters from abroad.
Even if the world can slow the spread of
the virus, Yiwu is testimony to some of theways in which people far and wide will feel
its economic effects. Agnes Taiwo, a busi-
nesswoman from Lagos, arrived in China
just as the government started its fight
against the epidemic. She had hoped to
make a bulk purchase of children’s shoes
and get back to Nigeria by early February.
Nearly one month on, she has not been able
to complete her order. And her return to Ni-
geria has been complicated because Egypt-
Air, the airline she flew on, has cancelled
all flights to China. “This is serious,” she
says. It is a sentiment that many others
around the world are starting to share. 7