Should Bond Benchmarks Shift from Traditional to GDP-Weighted Indices?

Some prominent institutional bond investors are shifting their focus away from traditional benchmark indices that weight countries’ debt issues by market capitalization, toward GDP-weighted indices. PIMCO (Pacific Investment Management Company, LLC, the world’s largest fixed-income investment firm) and the Government Pension Fund of Norway (one of the world’s largest Sovereign Wealth Funds), have both recently made moves in this direction.

There is a danger that some investors will lose sight of the purpose of a benchmark index. The benchmark exists to represent the views of the median investor dollar. For many investors, going with the benchmark is a good guideline - especially those who recognize themselves to be relatively unsophisticated and also those who think they are sophisticated but really aren’t. This is the implication of the Efficient Markets Hypothesis (EMH), for example.

On the one hand, EMH theorists are often too quick to discount the possibility of ways to beat the benchmark. To take an example, it should not have been so hard to figure out during the 2003-07 credit-fed boom that countries with high foreign-exchange-denominated debt, particularly in Europe, were not paying a sufficiently high return to compensate for risk. That mistake described Eastern European countries with low ratios of reserves to short-term debt as well as periphery euro members that lacked their own currency. It probably resulted from easy money, reach for yield, and pervasive underestimation of risk. Or, to take another example (admittedly, a tougher call), some of these countries’ deeply discounted bonds would have been good buys in early 2012, after heavy mark-downs.

On the other hand, most investors would do better if they went with a more passive investment strategy - especially due to high management fees among actively managed funds, exacerbated by excessive turnover. At a minimum, if one is pursuing an activist strategy such as investing more in low-debt countries, it is helpful to frame it explicitly as a departure from the view of the median investor in order to be clear in your mind as to the nature of the bet you are making.