The TEXPERS Blog

The Universal Benchmark for U.S. Fixed Income

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By Douglas Gimple, Guest Contributor

Measuring the ability of a fixed income manager to deliver excess return relative to a benchmark is a much more complicated proposal than comparing an equity manager to the S&P 500. 

The Bloomberg Barclays U.S. Aggregate Index (“the Index”) is considered the fixed income version of the S&P 500, which is widely used to represent equity markets through a capitalization-weighted index of 500 stocks. While the composition of the S&P 500 is based on the 500 largest companies listed on the NYSE or the NASDAQ and selected by a committee, the Index is strictly rules-based. As of December 31, 2018, the Index consists of 10,248 securities representing $20.8 trillion in assets, while the investment grade fixed income market, as measured by the Securities Industry and Financial Markets Association (SIFMA), consists of $38.1 trillion in assets.  The construction of the Index can limit the inclusion of certain areas of the market, so the rules-based nature of the Index creates various opportunities to exploit inefficiencies in the marketplace. 

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Source: SIFMA, Bloomberg. As of December 31, 2018.

Index Limitations Lead to Criticism (and Opportunity)

Prior to the Financial Crisis, the Index was considered the gold standard when it came to providing a benchmark for investors’ U.S. fixed income allocation. More recently, the Index has been criticized for being antiquated and not a true reflection of the investment opportunities in fixed income markets. Rules around inclusion have limited the Index’s exposure to certain areas of the market and limit the effectiveness in representing the investment grade U.S. fixed income market.

An example of the rules limiting exposure to the overall market is the asset-backed securities (ABS) sector. Per Barclays’ rules, the ABS sector of the Index contains only autos, credit cards, and stranded cost utility securities. Conversely, the ABS market, as measured by SIFMA, contains a variety of subsectors available to investors. Some of these sectors have grown substantially over the past several years, and offer clients an investment-grade alternative to other areas of the market. 

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Source: SIFMA, Barclays. As of December 31, 2018. Other includes but is not limited to cell phone contracts, consumer, franchise, property assessed clean energy, servicing advances, solar and timeshares.

Other sectors in the Index suffer from the same lack of inclusion as the ABS market. In the mortgage-backed securities (MBS) market, there is a large disparity between what is included in the Index and what is investable for the universe. While the residential MBS market is roughly $9.2 trillion, according to the Securities Industry and Financial Markets Association as of Dec. 31, 2018, the Index’s MBS allocation only consists of $5.9 trillion (as of Dec. 31, 2018), as it only holds agency MBS pass-through securities that meet index criteria. The Index does not include non-agency residential MBS securities ($817.2 billion) or agency collateralized mortgage obligation MBS securities ($1.1 trillion), both areas of the market that can deliver strong risk-adjusted returns relative to plain vanilla pass-through mortgages.

Opportunities Beyond the Benchmark

While a fixed income manager needs to be keenly aware of their assigned benchmark, they must also be willing to look beyond the rules-constrained Index to find opportunities. Utilizing areas of the market not included in the Index methodology expands the opportunity set beyond the standard securities found in the Index and helps to differentiate managers from competitors. 

The views expressed are those of Diamond Hill as of April 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.

Douglas Gimple

About the Author: 

Douglas Gimple serves as a senior portfolio specialist for Diamond Hill Capital Management and joined the firm in 2016. Prior to joining Diamond Hill, Gimple was executive director, Senior Client Portfolio Manager at J.P. Morgan Asset Management from 2004 to 2016. From 1995 to 2004, he was Institutional Investment Manager at Banc One Investment Advisors. Gimple has a Bachelor of Science in Finance from Miami University and a Master of Business Administration from the University of Dayton and holds the Series 7 and 63 FINRA securities licenses.