The Hindu Business Line : Index funds can bond with bonds

INDEX fund as a concept has been debated for quite some time now. The debate has, however, been restricted to the equity market. This column dated September 13, 2004 looked at the reasons why active portfolio management provides better risk-adjusted return to unit-holders in equity funds. The same argument may not hold for the bond market. Here is why.

Interest rate movement: Since 1999, bond funds have generated handsome returns for the unit-holders because of a secular decline in interest rates. But such a regime may well be over.

Whether interest rates have bottomed out is moot but the fact is that they are likely to be wobbly in the future. This means that all maturity sectors are unlikely to move up during any given investment horizon, as has happened in the past.

In such a scenario, yield curve preferences become an important driver for portfolio performance. A money manager should, hence, invest in maturity sectors that he or she perceives as undervalued relative to the yield curve.

This exerts pressure on the active money manager. Absolute returns are unlike to be as high as in the past. Unit-holders will, hence, be concerned on how their funds' perform relative to the peers.

Case for indexing: The structure of the bond market is quite unlike that of the equity market.

The level of noise trading is high in the equity market because of the presence of large number of non-institutional players.

Such noise trading provides scope for active funds to outperform the market even on a longer investment horizon. That is not the case with bond funds.

Noise trading is minimal in the bond market because of the absence of non-institutional players. The daily change in bond prices may be more due to liquidity consideration and portfolio changes rather than due to noise trading.

The lack of noise trading makes it difficult for a bond fund manager to consistently choose sectors that are relatively undervalued.

Moreover, it is difficult to believe that an institutional investor will display consistently superior skills at asset allocation and security selection compared to its peers.

Such a portfolio manager would be continually trading off liquidity risk for value. The active risk-adjusted return may not, hence, be high. There is, therefore, a case of investing in bond index funds.

Style indices: Birla Sun Life Mutual fund should be commended for kick starting bond index fund investment in the country.

The Birla Bond Index Fund is benchmarked to the CRISIL Composite Bond Index. This index is a composition of AAA Index, AA Index, Gilt Index, CP Index and Call Index.

The problem is that the asset allocation process is based on the three-month average of the universe of long-term debt funds.

This means that the fund does not follow a particular investment style. The purpose of investing in a broad index fund is to ensure that the portfolio is style-neutral. Tracking a universe of bond funds defeats this objective.

Sector-biases are bound to exist, especially because of the skewed preferences of the market participants. At present, majority of the market players expect the interest rate to move up.

Their portfolio may, therefore, have a sizable exposure at the short-end of the yield curve. An index that tracks the bond fund universe may, hence, be overweight on short-term bonds, which is a style-bias.

The problem is that the contours of such an index fund will change based on the market condition. This means that the investors cannot custom-tailor investments to match their liability requirement.

Index investors will be best served if fund-houses can instead launch index funds that carry distinct style-bias. Index investors who seek steady income without much erosion in capital may choose to invest in a long-term index fund.

Similarly, risk-averse investors may prefer to invest in short-term funds that offer high level of capital protection. Fund-houses should launch index products that can cater to such specific needs.

(Feedback can be sent to bvenky@thehindu.co.in)

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