Ten Questions With Jack Malvey

April 20, 2009


JoI: Should investable fixed-income benchmarks undergo any changes in light of our experiences in the last six months, and if so, how?

Malvey: Consistent with the natural evolution of global capital markets, index rules gradually change through time to better capture market reality. Since 1997, Lehman (now Barclays Capital) has conducted annual Index Advisory Councils on three continents (North America, Europe, Asia) to consider possible index modifications like liquidity, asset class additions/deletions and index analytics/technology. Biannually, these three groups, totaling nearly 100 major institutions of all classic types of debt investors, assemble for a Global Index Advisory Council.

Undoubtedly, the events of 2007–2010 will spawn vigorous council debates. In my view, major changes in the multidecade philosophy underlying broad macro benchmarks like the U.S. Aggregate Index, U.S. Universal Index, the Euro-Aggregate Index, the Global Aggregate Index and Multiverse Index will not be forthcoming. These indices were designed to be the broadest gauges of overall market performance and have well satisfied this function during this tumultuous period. This does not suggest nonresponsive index philosophy rigidity and by no means precludes a vast scope for index innovation over the early 2010s. But this innovation likely will be found mainly in the field of customized indices.

Every major capital market correction justifiably augurs a review of methods. The “great corporate governance fiasco” of 2001–2002, made infamous by Enron and WorldCom, led to the introduction of a suite of issuer-constrained investment-grade, high-yield and broader macro indices. Given that most customized indices emanate from a desire to reweight components to better reflect desired portfolio objectives and constraints, the experience of 2007–2010 will probably lead to further investigation of new index-weighting schemes. For instance, given the bold increase in world government bond supply, will investors want to be dragged by the gravitational pull of indices into portfolios with higher-and-higher weights in government bonds that offer lower returns through time? As in the equity arena, many debt investors share a basic discomfort with classical market-weighted indices.

Unfortunately for the discomforted, a broad consensus does not—and likely will not soon—exist on a satisfactory alternative to market-weighted bond indices. This lack of consensus surely will not impede ongoing experimentation through customized index channels to complement­—and perhaps someday very far in the future supplant—market-weighted indices.

JoI: What are the biggest issues facing the fixed-income market?

Malvey: On the tactical side, the global capital markets of 2009 will be centered on defining the economic trough, timing the accompanying valuation bottom for risky assets, searching for liquidity in a milieu of de-leveraging and consolidating broker-dealers, fretting about the inevitable government bond supply bulge-induced escalation of world yield curves to the detriment of absolute bond returns, and questioning the durability of concurrent U.S. dollar stability, and U.S. and non-U.S. budget-deficit expansion beyond world economic normalization.

On the strategic side, capital market professionals will be focused on the anticipation and implementation of new strategies in the face of major alterations in the legislative, regulatory, judicial, institutional, consumer, investor/broker-dealer model, and asset management philosophy frameworks. Early anticipators and adapters to this new and rapidly changing environment will have an inherent competitive advantage. As already shown in 2008, static financial organizations with nondynamic business philosophies face the highest risk of obsolescence and even extinction in a generation.

JoI: Does it make sense to use broad benchmarks like the Lehman Brothers Aggregate Bond Index to underlie investable products?

Malvey: As shown by the success of investable products like ETFs hinged to the U.S. Aggregate, U.S. Treasury and U.S. Treasury Inflation-Linked securities, broad bond benchmarks have met an essential need both from institutional and individual investors seeking to easily replicate the return/risk of key debt markets. Ahead, consideration should be given to the use of even broader macro benchmarks like the Global Aggregate Index and the Multiverse Index to mimic the performance of the entire world bond market. And boring in from the micro direction, there are dozens of potentially worthy narrower investable products that might be constructed from the hundreds of global debt index components. The beta replication of narrower index components (i.e., CMBS, corporates, Japanese RMBS, etc.) can free up total return bond managers to concentrate on their alpha-generating areas of expertise (i.e., currencies, curves, spread-products, asset allocation) in their quest to outperform formidable bond indices like the Global Aggregate Index.

JoI: Will the future of fixed-income indexes be more aligned with benchmarking/asset management or with the creation of tradable, investable products?

Malvey: The provision of accurate benchmarks for asset managers and the construction of tradable investable index products are not mutually exclusive. A strong index franchise should be able to undertake both pursuits simultaneously. If pushed to prioritize—and perhaps reflecting the thrust of my index tenure at Lehman—I would lean toward the supply of worthy benchmarks for asset managers. This is a nontrivial task. On the threshold of the second decade of the 21st century, the world bond market has not been fully mapped. A heavy emphasis on the creation of tradable index products could detract from properly resourcing the original classic benchmark function. And if not handled properly, the mix of benchmark provisioning with tradable investable index products could invite conflict conjectures from third parties. Finally, as alluded to above in your “aftermath question,” the impetus for innovation, solutions and structured products might well be dormant for an extended stretch until global capital markets fully recover and all the painful recent lessons are fully digested.

JoI: What do you see as the key trends to watch going forward in fixed-income indexing?

Malvey: At root, all asset class indices are measurement tools intended to provide institutional and individual investors, consultants, issuers and academics with a set of objective performance standards. Consistent with this guiding principle, the following trends in debt indexing may be observed over the next decade.

First, the world index map needs to be completed on a single-index platform in order to house a full measure of world bond market performance as has long been available for the global equity asset class. There are missing pieces, like an Islamic bond index and several worthy emerging-market local currency government and spread-sector markets. The creation of stand-alone indices for CMOs and certain types of structured product might be revisited. A suite of “real” indices (nominal return minus local inflation rate), an environmentally friendly “green index,” and a “socially responsible index,” might be helpful information tools. Insurers and plan sponsors might find constant portfolio (such as a book yield index) and constant duration indices useful.

Second, as investable ETFs proliferate, and as demanded by equity exchanges, bond index providers need to migrate to the standard long applied in equity markets—namely, real-time pricing.

Third, and consistent with the quest toward creating new index products, the next generation of debt index innovation might include more cross-asset combinations featuring elements drawn from debt, equity and commodity asset classes.

Fourth, while the number of broker-dealer index providers may shrink given stress-induced consolidations, behemoth global bond managers may be incented to create their own suite of specialty indices.

Fifth, like everything else in financial markets, additional regulatory oversight in some form would not surprise.

Sixth, the components of macro indices will be expanded. The eventual full convertibility of Chinese and Indian currencies will render their debt eligible for inclusion in the Global Aggregate Index and spur increased international demand for their securities.

Seventh, new product innovation will not lay fallow forever. The 2010s surely will see new portfolio management strategies accompanied by more debt ETFs, customized indices, liability-driven benchmarks and specialty-structured indices.

Eighth, recognizing that index mastery can often deliver persistent alpha in the bunched realm of competitive debt asset management performance, professional index specialists will be included on the asset management committees of first-tier asset management firms.

Overall, the further development and application of bond indices will be one of the most exciting and fastest-growing areas of finance over the coming decade.


[Editor's Note: The Lehman indexes are now managed by Barclays Capital.]



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