Actively Designed, Passively Managed

Institutional investors often omit or hastily consider an important step in the investment decision process, namely selecting and refining the respective indices to be used. In doing so, investors may be missing an opportunity to truly understand the indices they are using and the potential exposure they are receiving through fully or partially replicated portfolios.

Prior to executing investment decisions, institutional investors undertake extensive research and analysis to decide on the optimal mix of asset classes designed to meet their investment objectives. Their next step is to decide between an active or passive manager, and that decision likely will be driven by whether they believe the active manager can outperform the markets within their asset allocation. However, investors increasingly are choosing a mix of both active and passive managers to get the best of both worlds. Unfortunately, investors frequently move directly to the time-consuming process of manager selection and monitoring.

In bypassing an in-depth index analysis, investors may be unaware that the index could be skewed in an undesirable manner because indices are generally constructed on a market capitalization weighting.

With actively designed benchmarks, however, investors can tailor the index to meet their exact requirements based on their objectives, risk tolerance, liabilities, sector or home bias and liquidity needs. The investor would then create a passively managed portfolio that tracks, not outperforms, the customized index. In other words, the “active bets” or exposures are embedded in the custom benchmark, which is then passively managed. This approach also lends itself to tactical asset allocation opportunities to take advantage of current investment themes. Building an investment theme into an index allows investors to exercise greater control over their total risk/return framework.

Barclays Capital Euro Government Index

Take for example, the Barclays Capital Euro Government Index, a market capitalization-weighted benchmark of European government bonds. Investors selecting this index for their passive investments would find themselves with relatively high exposures to lower-rated countries, meaning that market beta would result in 28% of their portfolio being allocated to government bonds with a rating of A or lower. Furthermore, the overall benchmark duration is six years. An investor may wish to consider whether this duration is ideally suited to their liabilities and extend or reduce this based on their objectives.

Barcap Euro Treasury	Count	Market Value %	Market Value	Yield	Duration	OAS	Rating
Austria	18	4.18	167,837,904	3.157	6.17	32.0	AAA
Finland	10	1.46	58,793,539	2.839	5.18	16.7	AAA
France	42	22.40	900,280,074	3.003	6.29	24.2	AAA
Germany	46	21.56	866,562,644	2.670	5.93	0.8	AAA
Luxembourg	2	0.10	4,124,215	2.896	4.96	30.1	AAA
Netherlands	18	5.69	228,667,390	2.866	6.11	13.5	AAA
Belgium	22	6.04	242,943,466	3.456	5.76	72.6	AA
Slovenia	10	0.30	12,005,492	4.212	6.56	117.0	AA
Spain	31	10.16	408,510,789	4.348	5.70	161.7	AA
Cyprus	5	0.15	5,924,391	5.251	3.00	307.1	A
Italy	52	23.78	955,668,473	4.122	6.15	129.3	A
Malta	3	0.03	1,340,153	3.388	4.14	99.5	A
Slovakia	13	0.47	19,009,010	3.692	4.83	106.8	A
Ireland	9	1.54	61,893,673	9.889	4.97	687.0	BBB
Portugal	14	2.13	85,695,804	8.282	4.80	547.5	BBB
Total	295	100.00	4,019,257,019	3.586	5.99	83.1

* Source: Northern Trust and Citibank as of March 31, 2011

In this situation, an investor looking for European government exposure could consider an actively designed, passively managed index approach that offers the flexibility to tailor benchmark exposures while benefitting from the reduced cost of using an index fund manager vs. an active manager. There would be a number of options that could be considered independently or in conjunction.

For example, consider a hypothetical investor with a long-duration liability based in the Netherlands with exposure to the Barclays Capital Euro Treasury index. From an investment theme and investment objective standpoint, they are seeking to increase duration and have concerns over the European sovereign debt crisis.

Here’s an illustration of the process of actively designing the benchmark:

• Add a high quality bias to selected triple-A rated governments and remove all lower-rated countries.
• Increase the duration to reduce the asset/liability mismatch.
• Increase exposure to Dutch issuance to create a home-country bias.

Custom Index	Count	Custom Weight %	Yield	Duration	Rating
Germany +15 years	10	35	3.84	13.76	AAA
France +15 years	8	35	4.14	14.46	AAA
Netherlands	17	30	2.88	6.10	AAA
Statistics	35	100	3.66	11.71

* Source: Northern Trust and Citibank as of March 31, 2011

By making these changes and passively managing a portfolio relative to the actively designed index, the hypothetical investor would reduce the index constituents to 35 from 295 and make full replication achievable. In addition, the average duration increases to 11.71 years from 5.99 years, thus reducing the asset/liability mismatch.

Furthermore, the yield of the tailored index would be 3.66% as of March 31, 2011 vs. 3.59% for the original index; therefore there is little difference on the running yield between them. Crucially, you have a higher credit-quality index with a home bias toward Dutch bonds.

Barclays Capital Global Treasury Index

Let’s consider another example, the Barclays Global Treasury Index. Once again this index is market capitalization weighted and highly skewed toward the United States and Japan, with limited exposure to some of the highly rated but smaller nations. With almost 1,200 constituent members, the broad index would be difficult to replicate. For this example, our investor is seeking high-quality global government ex-Eurozone exposure, but is concerned with indebted nations having high exposures within the index.

Barcap Global Treasury	Count	MV%	MV	Duration	Yield	Rating S&P
United States	196	24.8%	4,987,612,324	5.31	2.01	AAA
United Kingdom	35	6.5%	1,303,840,963	8.87	3.25	AAA
France	42	6.1%	1,226,261,347	6.69	2.79	AAA
Germany	47	6.0%	1,211,832,842	6.21	2.41	AAA
Canada	34	1.9%	372,764,384	6.13	2.62	AAA
Netherlands	17	1.5%	304,896,997	6.48	2.63	AAA
Austria	18	1.2%	233,070,263	6.50	2.93	AAA
Australia	14	0.7%	146,426,121	4.13	5.24	AAA
Denmark	9	0.5%	109,580,709	7.38	2.66	AAA
Switzerland	18	0.5%	95,574,389	6.98	1.40	AAA
Sweden	9	0.4%	89,836,363	6.02	3.00	AAA
Finland	10	0.4%	81,626,640	5.49	2.60	AAA
Singapore	17	0.3%	57,182,511	5.33	1.47	AAA
Norway	5	0.2%	37,725,695	4.35	3.08	AAA
Luxembourg	2	0.0%	5,717,449	5.26	2.68	AAA
Hong Kong	5	0.0%	2,791,829	4.03	1.49	AAA
New Zealand	5	0.1%	30,079,574	4.68	4.67	AA+
Japan	263	31.6%	6,372,063,714	7.26	0.88	AA
Spain	30	2.7%	540,870,220	6.00	4.38	AA
Belgium	22	1.7%	339,323,071	5.78	3.43	AA
Taiwan	72	0.7%	139,360,068	7.32	1.38	AA
Slovenia	9	0.1%	14,700,098	6.41	3.90	AA
Italy	52	6.5%	1,307,015,820	6.45	4.10	A+
S. Korea	79	1.7%	352,301,448	3.90	4.07	A+
Portugal	14	0.6%	124,485,954	5.43	6.52	A+
Czech Rep	15	0.2%	46,298,144	6.01	3.36	A+
Slovakia	13	0.1%	26,371,256	5.14	3.54	A+
Chile	8	0.0%	3,780,469	3.27	6.00	A+
Cyprus	5	0.0%	8,140,866	3.25	5.09	A
Malta	3	0.0%	1,871,648	4.41	3.17	A
Poland	16	0.6%	117,250,598	3.89	5.50	A-
Ireland	10	0.5%	98,196,161	5.20	8.27	A-
Malaysia	27	0.4%	74,719,405	4.43	3.55	A-
S. Africa	11	0.4%	71,114,413	5.89	8.36	BBB+
Mexico	19	0.5%	110,604,522	5.20	6.91	BBB
Thailand	35	0.3%	61,230,965	6.02	3.68	BBB-
Hungary	12	0.2%	35,863,907	3.83	6.92	BBB-
Total	1,198	100%	20,142,383,147	6.43	2.28

* Source: Northern Trust and Citibank as of March 31, 2011

In addition to Eurozone countries, countries with a rating below AAA were removed. The remaining eight AAA countries were equally weighted within the new index to provide better country diversification and to dampen over exposure to the United States. In doing this, the constituent members were reduced to 291 and the overall duration of the index was reduced to 5.74 years from 6.43 years, but the yield increased to 3.02% from 2.28% in February. This approach resulted in a higher credit-quality index, better country diversification and a higher running yield than the Barclays Global Treasury Index.

Global AAA ex Eurozone	Custom Weight %	Rating
Australia	12.50	AAA
Canada	12.50	AAA
Denmark	12.50	AAA
Norway	12.50	AAA
Sweden	12.50	AAA
Switzerland	12.50	AAA
United Kingdom	12.50	AAA
USA	12.50	AAA
Statistics	100

*Source: Northern Trust and Citibank as of March 31, 2011

These examples offer a glimpse of how an actively designed, passively managed benchmark can help an investor understand the exposures within the index and align these with the established investment objectives.

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