Portfolio managers adopt different investment approaches dependent on their client’s objectives and constraints. The styles vary between those taking a benchmark driven total return approach at one end of the spectrum to those which are more Buy and Hold/Buy and Maintain in nature. A total return approach implies a higher level of turnover, adding to transaction costs, while the opposite is true of a Buy and Hold/Buy and Maintain approach. Since the financial crisis, there has been an increased concern around the lack of liquidity in corporate bond markets and the consequent increase in trading costs. This had led some to question the benefit of higher turnover investment strategies, resulting in strong demand for low turnover Buy and Hold and Buy and Maintain ones. The question then is how best to track the client’s long term risk and return appetite and liability profile as specified in their investment objectives. While traditional benchmarks are suitable for a total return benchmark driven approach to investing, are they suitable for Buy and Hold strategies?
The total return approach to investing involves tracking, to a degree, a specific benchmark which generally sets out a client’s specific risk and return profile. It also allows client’s to assess their managers performance and helps guide them on how a portfolio should be invested. However, benchmarks by the nature of their construction do have shortcomings and are not suitable for all strategies. Those shortcomings include compositional changes impacting the benchmark characteristics which prompt rebalancing, or not, of strategies by portfolio managers. The composition of benchmarks change for reasons including new issues, maturing bonds, rising stars and falling angels. We discuss these in more detail below. The changes have the impact of either increasing annual turnover or tracking error, often contradicting the objective of stable income which is the cornerstone of Buy and Hold and Buy and Maintain strategies. We describe four different strategies and identify the implications of using benchmarks on turnover and volatility.
Bond benchmarks are meaningfully different from traditional equity benchmarks in that their natural turnover depends on several different factors which change the composition of the benchmark each time it is rebalanced. In fact, the European fixed income corporate universe (as measured using BofAML European Investment Grade Corporate Bond Index) has an annual turnover of approximately 40%. The key factors driving this turnover are:
So, are benchmarks appropriate for Buy & Hold strategies? We think not. This is because the construction and monthly rebalancing of traditional benchmarks leads to an unnecessary increase in portfolio turnover. The existence of a benchmark serves as a performance measurement tool for total return benchmark strategies where managers are conscious of their relative risk and return profile versus an index. However, performance versus a benchmark is less relevant for Buy and Maintain strategies where the primary objective is the provision of stable income. Another way to help mitigate turnover whilst taking into account the changes in benchmark dynamics would be to fund the strategy with several cohort portfolios through time that relates to the benchmark of reference at that point in time.