By the Financial Times (Financial TimesBond markets may be twitchy at the prospect of a deluge of refinancing by Spain, Portugal and Italy this week, but at least southern European finance ministers can rely on managers of indexed funds to absorb much of the supply of new sovereign debt. An important question for the rest of us is whether passive bond investment that seeks to replicate index returns might have wider malign consequences. The short answer is yes. The disadvantages of passive investment strategies were at their most obvious in the high-tech boom of the late 1990s. Since the weight of securities in an index is dictated by market capitalisation, there is a tendency for passive managers to invest more in shares that are becoming overvalued. In effect, the rules of the game demand that if shares have gone up, so increasing their weight in the index, the managers have to buy more. By the same token, when shares have gone down, causing shrinkage in market capitalisation weight, they have to sell them. This amounts to a value-destroying injunction to buy high and sell low. In the dotcom era, it put significantly more puff into the stock market bubble and ensured a more painful time for all when the bubble eventually burst. In the bond market, the impact of indexed investing is arguably more damaging. One reason is that it makes life easier for the most heavily indebted borrowers. Advanced country sovereign debt is by far the biggest chunk of global fixed interest indices. As Ramin Toloui of the big Pimco bond fund manager notes, such market capitalisation weighted indices are poised to increase this concentration further, especially in countries where debt is growing most. In other words, some of the least creditworthy borrowers in the system will enjoy ready access to funds regardless. Note, too, that a much greater proportion of bond market money is indexed or closet-indexed - that is, supposedly active managers hug the index to minimise the risk of underperformance - than in the equity market. Given the size of the sovereign debt market, it seems probable that global and regional imbalances such as those fostered by the malfunctioning of the monetary union will have been exacerbated by this perverse investment behaviour.
Certainly indexed investing cannot serve investors well in the face of such huge changes in investment perception as the credit markets have experienced during the past year, whereby credit risk, as opposed to interest rate volatility, has become a central preoccupation in sovereign debt markets. This has led to historically unusual pricing such as high quality corporate bonds trading at lower credit default swap premiums than those of their own governments. Clearly global capital is being seriously misallocated when so much money is driven by criteria remote from underlying value. What is perverse, from the point of view of the end-investors in these funds, may also be perverse from a broader economic perspective since passive money is encouraging highly indebted countries to take on even more debt. Given the extremity of the sovereign debt crisis in Europe, it is hard to believe that this can continue. Market anomalies invariably unwind in the end. In fact, the process is already under way. Pimco, to name but one, already offers an alternative to market capitalisation weighting. It has developed an index that uses gross domestic product to set the weights in the index rather than outstanding stocks of debt. Part of the attraction is that it makes sense to lend to countries with high incomes rather than heavy debt burdens. It also results in a much larger allocation to emerging markets. This, too, has its attractions because of the complete tunround in the relative position of the developed and developing world in debt terms since the Asian crisis of 1997-8. And as Pimco's Mr Toloui argues, low debt in many emerging markets means they have more flexibility in financing future growth than developed countries where the ageing of populations and rising entitlement spending are a huge fiscal constraint. Other fund managers prefer to eschew indexing completely. London-based investment manager Stratton Street Capital uses a model based on countries' net foreign asset position - the value of assets held abroad minus debts owed to foreigners - which helped it emerge from the 2008 market meltdown without losing money. Its funds focus on the world's leading creditor countries.
Stratton Street's Andy Seaman argues that the current opportunity to buy the debt of the world's main creditors at the same yield and spread as major debtors is very unusual and will not be sustained. At the very least, the workings of indexed investment in the sovereign debt market merit a rethink by central banks and pension fund trustees. The status quo is a nonsense. The writer is an FT columnist