Playing around with the Barclays Global Agg

Events from Lehman Brother’s bankruptcy to the near-default by the United States in August last year have prompted investors to rethink benchmarks.

These indices give form and shape to an institutional investor’s view of the world, but the Western financial crises have thrown into doubt fixed-income benchmarks that automatically raise one’s exposure to the most heavily indebted governments.

Nevertheless, indices such as the Barclays Global Aggregate, which is based on market-capitalisation weightings, remain by far the most common tools for investors to base their strategy.

Until very recently, this benchmark index did work very well, and although investors are increasingly customising indices or experimenting with factor-weighted variants, these have their own drawbacks – and many institutional technocrats face considerable career risk if they deviate from long-standing practice.

So global investors stick with benchmarks such as the Barclays Global Agg, even though they have concerns about following it too closely.

Anthony Chan, director of iShares Asia research and investment advisory at BlackRock, says investors do have the tools to improve upon the Barclays Agg without having to ditch it. He says by using exchange-traded funds they can break such benchmarks into their constituent parts and reassemble them more intelligently. (iShares manufactures ETFs.)

Chan argues that investors can accurately recreate an index’s exposures but tilted toward greater or lesser yield, for example, or volatility. That can allow them to allocate more to, say, high-yield bonds in a more risk-controlled manner.

The Barclays Global Aggregate is the broadest fixed-income index in existence. It is the universe, with over 11,000 securities in its composition, spanning all geographies. It includes government securities as well as corporate bonds, agency bonds, mortgage-backed securities and other asset-backed securities.

But the biggest portions are US Treasuries and Japanese government bonds, two low-yielding asset types that are only ephemerally ‘risk free’.

Chan suggests investors could chop up the Barclays Global Agg into basic blocks – geography, sector – and mix them with other benchmark indices that replicate those exposures in a different manner.

For example, an investor could retain the Barclays Global Agg’s US and European constituents, along with its Asia local-currency piece. They could add the S&P/Citi International Treasuries Index and the JP Morgan Emerging Market Bond Index Core Global.

Together these recreate much of the original Barcap Global Agg exposure over the short run. For example, this sort of mishmash should track the original index closely on a three-month or even a one-year basis.

Over a longer period it will deviate, which is why investors should create and recreate these exposures via ETFs, which are easy to create and redeem. Investors can give themselves a benchmark exposure similar to the Barcap Global Agg, but with a different risk/return profile. With careful tweaking, they can either tilt exposures to reach a particular goal, or to ensure the tracking error of the new composite remains close to that of the original benchmark.

This is one way, for example, to increase exposure to emerging-market debt without affecting the total risk of the portfolio (in tracking error terms).

Chan made the argument at AsianInvestor’s recent Korea Institutional Investment Forum in Seoul.