The Economist 29Feb2020

The EconomistFebruary 29th 2020 Finance & economics 59

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Buttonwood Benchmarkblues

I

maginea worldinwhichthestock-

markethasonlytwoconstituents:

Gurgle,a firmthathasrisenquickly,and

GenialMotors,a maturecompany.Both

have100mofsharesoutstanding,each

worth$1.Thatgivesthemarketa valueof

$200m.Furtherimaginethatthereare

twoinvestorsofequalsizeinthemarket.

Bothownthesameno-costindexfund.

Eachhaswealthof$100m,splitbetween

GurgleandGenialstock.

Aftera yearGurgletriplesinvalueto

$3a share,whileGenialstaysat$1.The

markethasdoubledto$400m.Three-

quartersofitsvalueisinGurglestock.

Bothinvestorsstillhold50msharesof

eachfirm.Theirtotalholdingsarenow

worth$200meach:$150m-worthof

Gurgle;$50mofGenial.Theyhaveshared

inthemarket’ssurge.Thisisa qualityof

passiveinvestmentinanindexweighted

byvalue.If somestockssoarinprice,you

shareproportionatelyintheirsuccess.

Butsayourinvestorswereactive

ratherthanpassive,withoneholding

100msharesofGurgleandtheother

100mofGenial.TheGurgleinvestor

tripleshiswealth;theGenialinvestor’s

wealthisunchanged.Simplemaths

meanthatif oneactiveinvestorbeatsthe

index,anothermustbebeatenbyit.And

sinceactiveequitymanagershavehigher

feesthanpassiveones,activeinvestingis

onaveragea losinggameinreallife.Few

beattheindexconsistently.Butthereisa

twist.Thisdoesnotholdforactivebond

investors.Mostbeattheindex.Thereisa

kinkinthelogicofindexinvestingthat

activebondinvestorsareabletoexploit.

Inanidealisedversionofpassive

investing,theuniverseofsecurities

remainsunchangedfromstarttofinish.

Butintherealworldtheindexchanges

fromtimetotime.Newfirmscometothe

marketviainitialpublicofferings(ipos).

Existingfirmsmayissuemorestockor

retiresome.A fewaretakenprivate.Anda

benchmarklikethes&p 500 isnotthe

wholemarket,butthelargestlistedfirms

init.Anindexfundmustoccasionallybuy

stocksthatgainenoughmasstoqualifyfor

theindexandsellstocksthatfalloutofit.

Soit isnotentirelypassive.Indexfunds

musttrade—andactiveinvestorscantrade

aheadofthem.

Inpractice,theturnoverinstocks

withinequityindicesisnotlargeenough

tohandicapthepassivefundsagainst

activemanagers.ipos areincreasingly

rare.Trafficinandoutofindicesislight.

Bondsaredifferent.A shareisa perpet-

ualsecurity,butbondshavefinitelives.

Mostofthemarequiteshort:theaverage

maturityofa Treasurybondissixyears.So

thereisa lotofmovementinandoutofa

bondindex.Anindexfundhastotradea

lotjusttomatchtheindex.

Thereissimplymorescopeinbond

marketsforwinninginvestorstofind

willingloserstobetagainst.A lotofinsti-

tutionalinvestorsareconstrainedinwhat

kindofbondstheyareallowed(orneed)to

hold.Theymaybebarredfromholding

corporatebondsorbondsthatarenot

ratedinvestmentgrade.Ortheymay

needtoholdbondsofcertainmaturities

forregulatoryreasons.

Themanagersofforeignreserves,for

instance,prizeliquidity,soholdmostly

short-termbonds.Banksfacecapital

chargesoncorporatebonds,sopreferto

holdgovernmentbonds.Insurance

companieshavelong-livedpromisesto

policyholderstoliveupto.Thatcreatesa

particularthirstforlong-datedbonds.In

all,therearea lotofbond-buyerswith

goalsotherthanbeatingtheindexfrom

oneyeartothenext.Ananalysis*by

JamilBaz,HelenGuo,RaviMattuand

JamesMooreofpimco, a giantbond-

fundmanager,puttheproportionof

bondsheldbysuch“non-economic”

playersataroundhalf.Activemanagers

canwinbyholdingmaturitiesthatare

lessindemand,bytiltingtowardscor-

poratebondsintheindex,orbymaking

off-indexbetsonjunkbonds—inshort

bydoingallthethingsconstrainedbond-

buyerscannot,orwillnot,do.

A tragicflawofbondindicesisthat

theyrewardprofligacy.Bigissuersof

bondshavea biggerweight.Sohigh-debt

Italyloomslargeringlobalbondbench-

marksthanthriftyGermany.Inequity

indicesthereissomerelationshipof

weightintheindextoeconomicsuc-

cess—oratleasttoinvestorenthusiasm.

Gurgle-likesharesentertheindexand

makeupmoreofitsheft;GenialMotors-

likesharesdiminishinweight,until

eventuallytheyslipout.Smartactive

investorscantradeaheadofsuchentries

andexits.Butit isslimpickings.With

bonds,therearemoreopportunitiesfor

activeinvestorstowin.

Whyactivebondinvestorscanbeattheindexwhenactiveequityinvestorscan’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 the

ways 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