While bond indexing has traditionally been considered either irrelevant or impractical, it appears to be hitting its stride in Canada

March, 1998 Benefits Canada - In a recent survey, Benefits Canada reported that pension assets managed by the Top 40 money managers grew by 26.5% in 1997. Against this backdrop, assets managed by Canadian indexers grew 52% last year, roughly double the overall growth in pension assets. While it is clear that the number of converts to indexing among institutional investors is growing, it is less apparent how many sponsors are opting for bond indexing.

For years, bond indexing was considered to be either irrelevant or impractical in Canada. Although there was considerable debate over the merits of active versus passive investment in equities, bond indexing received scant mention. Nonetheless, several plan sponsors and investment managers quietly launched bond index funds in the early 1990s. As a result, while still relatively new, bond indexing appears to be hitting its stride in Canada.

The numbers speak for themselves. A recent Greenwich Associates survey of nearly 300 large Canadian pension plans reported that 12% employed bond indexing in 1997 --- up from just 2% in 1993. This compares with 15% of survey respondents who used indexing for U.S. and Canadian equities.

Many investors who do opt for bond indexing use institutional pooled funds to do so. In the 1997 Benefits Canada To 40 Survey, this group accounted for more than $5 billion in assets, representing about 35% of the pooled Canadian bond total. This is in addition to the pension plan sponsors who have opted for segregated (i.e. individually-managed) indexed bond portfolios.

Bond Indexing Defined
With indexing, assets are invested in such a way that the performance of the portfolio matches that of a specific market index. In Canada, bond index funds commonly target the Scotia Capital Markets Universe (SCMU) Bond Index. In some cases, however, an investor may opt for a sub-component of the index, such as short, mid or long bonds, corporate bonds or government bonds only.

There are two basic approaches to indexing:

The first, known as replication, involves duplicating the target index precisely, holding all its securities in their exact proportions. Once replication is achieved, trading in the indexed portfolio becomes necessary only when the make-up of the index changes or as a way of re-investing cash flows. While this approach is often preferred for equities, it is neither practical nor necessary with Canadian bonds. This is mainly due to the fact that many of the more than 750 bond issues in the SCMU Index, for example, rarely trade. Many are used in liability matching programs of pension funds and insurance companies and are often held to maturity. Others are ready substitutes for each other. A 10-year Canada bond issued in 1992, for example, will have very similar performance to a five-year Canada bond issued in 1997.

An alternative approach, known as optimization or sampling, seeks to reproduce the overall attributes of the index (yield, credit quality, duration, convexity, etc.) with a limited number of issues. While this may sound simple in theory, it is difficult to achieve in practice. Passive does not mean inactive. In fact, it takes very active portfolio management processes to deliver reliable index performance with low tracking error. It requires extensive portfolio modeling and monitoring, together with very disciplined and cost-conscious trading capabilities.

Why All the Fuss?
There are many reasons for the growing use of indexing in Canadian bond portfolios, the primary one being that the median bond manager has failed to consistently demonstrate added value. The inability of active bond managers to outperform the SCMU Bond Index over time has well been documented. As a result, many bond managers hug the index, hoping to add marginal value by trying to spot mis-priced securities or by taking very modest duration bets. An examination of annual return differentials between the median manager and the index reveals no predictable pattern, other than that annual differentials have been getting smaller. All of this may be evidence that Canadian bond markets are becoming more efficient.

Not only has median manager performance become a virtual proxy for index returns, bond managers' results --- over long longer time periods --- have tended to regress towards the mean. In other words, adding value relative to the market becomes progressively more elusive as the investment horizon is extended. Furthermore, in the long run, both the likelihood and the scope for adding value are quite limited. Over the past 10 years, for example, the first quartile break was just 0.2% above the index return.

Other explanations for the popularity of bond indexing include the following:

1. Broad diversification reduces risk. As the number of securities in the portfolio increases, the potential negative impact of individual security volatility on the portfolio decreases.

2. Bond indexing offers market returns reliably at a lower cost. An important feature of indexing is its cost-effectiveness. This is a result of two primary cost savings. First, transaction costs, like commissions (incorporated in the bid/ask spread) and market impact, are reduced because of low portfolio turnover. As well, investment management fees are lower for indexed than for active management.

3. Growing acceptance of indexing in Canada means plan sponsors are more familiar with its advantages and therefore are more prepared to investigate bond indexing as an alternative to traditional active management.

4. The availability of institutional pooled funds eliminates the "critical mass" barrier for smaller pension funds. Often a minimum of $30 million or more is required to establish a reasonably well diversified index-tracking portfolio. However, plan sponsors can invest much smaller amounts in units of a pooled index fund and, further, are relieved of the hassles and expense of custody and recordkeeping.

5. Manager selection risk is eliminated. With the growth of money purchase retirement savings plans, sponsors are becoming more aware that their fiduciary responsibilities to plan members differ from those in defined benefit plans. In particular, they face the risk of being called to task by plan members when a manager selected for the money purchase plan suffers a prolonged period of under-performance. Sponsors, therefore, have one less risk to manage with index funds.

Plan Sponsor Options
While some sponsors have opted to index the entire bond component of their investment program, indexed bonds often are used in combination with other strategies.

Some maintain that by indexing bonds, they are better able to focus their active management resources. These sponsors prefer to concentrate on less efficient asset classes or markets where research has better prospects for adding value. Not only is this a more effective allocation of scarce resources (and investment budgets), it also simplifies the fiduciary's oversight process.

Larger funds, where full indexing may not be practical, might consider a core/satellite approach. This involves indexing a core portion within the fixed income asset class and supplementing with carefully selected specialist managers (e.g. mortgages, high yield bonds or other value added approaches).

One other alternative is to use indexed bonds within an asset allocation (or systematic re-balancing) program. Even active managers who can successfully add value within an asset class are rarely able to add value through allocation among asset classes. Transaction costs can be high --- whether explicit market timing calls are being made or the plan is being re-balanced to meet its asset mix policy targets. By contrast, index fund transactions can be implemented at a substantially lower cost. Another, harder to measure cost is incurred when shifting assets from one active manager to another. If the assets involved are substantial, this can disrupt the management of both portfolios. Shifting between two index funds causes minimal disruption.

As for smaller plans, pooled index funds offer excellent liquidity, and some pooled fund managers have the ability to cross securities and pooled fund units internally to minimize --- or even eliminate --- transaction costs.

A Long-Term Perspective
As the share of indexing has grown, it has already begun to put downward pressure on active bond management fees. As well, some active managers have resorted to offering indexing as a way of preserving their market share. This trend could definitely intensify and incentive fees for value added are likely to become more common.

The trend to bond indexing could well serve to separate true value-added managers from others who have only occasional or sporadic success. Ironically, indexing may end up improving the quality of active management. In general, sponsors will become more sophisticated and discriminating in both the manager selection process and in monitoring investment performance. Already, some are moving towards evaluating risk-adjusted, after-fees performance.

One trend is clear: as long as active management fails to demonstrate long-term value-added after fees that are reliable, the boom in bond indexing will continue.

The Lure of Indexing
For many years, indexing in Canada was virtually synonymous with large defined benefit pension investment programs. Its use by some of the biggest pension funds in the country --- particularly the public sector mega-funds like the Ontario Municipal Employees Retirement System (OMERS) and Ontario Teachers' --- has been well documented.

For large funds, indexing offers other features besides a way to earn reliable market returns at a low cost:

1. Indexing in more efficient markets enables some to concentrate on less efficient markets, where research is perceived to be better rewarded.

2. It furnishes a tool to manage an asset mix more effectively than moving money between active managers.

However, the popularity of indexing has also grown among small-to-mid-sized pension plans. The main vehicle for these plans (as well as for some not-so-small ones) has become the indexed pooled fund. While these are similar to mutual funds, they are designed (and priced) primarily for institutional investors. Like their larger segregated fund cousins, these pooled funds offer broader diversification and lower costs than active management, as well as good liquidity. Added to this is the convenience of outsourcing investment management --- in addition to proxy voting, portfolio accounting and custody --- in one tiny package.

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