Monday, March 15, 2010

FLG Had Never Thought Of This Before

While the argument for investing in the equity benchmark has a lot of merit (low cost, the difficulty in finding an outperforming manager), the case for using bond benchmarks is deeply flawed.

FLG isn't about to sell his Lehman Barclays Aggregate bond fund, but he'd never thought through the fundamental differences between equity and bond indexes.

1 comment:

Andrew Stevens said...

And the indices would be dominated by those who had borrowed most; in effect those who followed the benchmark were deliberately focusing on the riskiest debtors. As Mr Cooper puts it, "an equity benchmark is asset-weighted, a bond benchmark is liability-weighted."

I agree with Mr. Cooper's statement in the second sentence. However, it does not follow that the nations or companies which borrow the most are the riskiest debtors as the first sentence maintains, though that's an easy assumption to make. In fact, my own guess is that it's false. E.g., the biggest debtor in the world is the U.S. government (and U.S. Treasuries are the single largest holding in the Barclays Aggregate Bond Fund) and it is very, very, very far from the riskiest debtor. In fact, there's an excellent case to be made that it's the safest given its revenues and, more importantly, its potential revenues if it decided to sell all its land out West and tax the bejesus out of its tax base.

Even if Buttonwood was right (and I'm pretty certain he isn't), the Barclays Aggregate Bond Fund is limited to investment grade bonds in any case. Now, if one is talking about a junk bond index fund with high yield bonds, then Buttonwood's argument would have more weight. It might be the case, when one gets down to lower ratings, that more debt equals riskier. It's probably still not true, but it might be true.

Having said all of that, he still makes a good point; he's just overselling it. Flawed? Yes. Deeply flawed? Nah.

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