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Sector Neutral Benchmarks: An Attractive Alternative to Traditional Benchmarks Executive Summary
After the volatile market environment in 2002, many fixed income investors have
begun to revisit traditional benchmarks and their influence on a portfolio managers
investment decisions. Specifically, some investors have raised concerns about large
sector, sub-sector or issuer allocations, particularly regarding corporate bonds. As a
result, some investors have begun to explore alternative benchmarks.
One increasingly popular alternative to a traditional benchmark is a sector neutral
benchmark. This type of benchmark may be composed of swap index sub-
components
1
weighted to reflect the investors target interest rate risk profile. Swap-
based sector neutral benchmarks can be attractive to many investors, as they do
not have specific sector concentrations and issuer weights. They do, however, have
specific duration and term structure targets.
This paper will:
I.
Explore the investment implications of fixed income benchmarks
II.
Outline the need for an alternative to traditional benchmarks
III.
Offer a solution: sector neutral benchmarks
IV.
Use a case study to explore how the choice of a sector neutral benchmark
impacts the construction of a portfolio
V.
Provide a methodology to construct a sector neutral benchmark that matches a
specific liability stream
VI.
Summarize the benefits of a sector neutral benchmark
NOVEMBER 2003
1
Until recently, total return indices based upon swap rates were not readily available from index providers.
However, index providers are now publishing such indices with maturities out to thirty years. In the past, some
investors used Treasury securities to develop these types of sector neutral benchmarks but swaps are now more
appropriate as they are increasingly viewed as the benchmark rate.
Sector Neutral Benchmarks:
An Attractive Alternative to Traditional Benchmarks
Swap-based sector neutral
benchmarks are an attractive
alternative to traditional
benchmarks because they do not
have sector or issuer weights, but
they do have duration and term
structure targets.
Perspectives
Insights on Todays Investment Issues
CHRIS BLUME
Vice President, Head of
Financial Institutions and
Structured Portfolios Goldman Sachs Asset Management | 2
Perspectives | Sector Neutral Benchmarks: An Attractive Alternative to Traditional Benchmarks
Author
Chris Blume
Vice President; Head of Financial Institutions and Structured Portfolios
(212-357-0741)
Chris Blume is a Fixed Income Portfolio Manager and Head of our Financial Institutions
and Structured Portfolios Group. In this position, he is responsible for overseeing bank
and insurance portfolios as well as portfolios with specific structuring requirements. Prior
to this role, he was the US Fixed Income Team's general strategist and was a member of
the risk team, where he developed the group's internal risk and performance attribution
systems. Before joining Goldman Sachs Asset Management in 1994, he worked for three
years as an Assistant Vice President in J.P. Morgan Investment Management's Capital
Market Research Department. He received a B.S. in 1989 and an M.B.A. in 1994 from the
Wharton School at the University of Pennsylvania. Goldman Sachs Asset Management | 3
I. Investment Implications of Fixed Income Benchmarks
Benchmark selection is one of the most important decisions an investor can make. The
benchmark not only serves as a way to evaluate a managers performance, but it also
identifies the investors strategic preferences, which, in turn, impacts the managers
investment decisions.
Strategic Investment Implications
When selecting a benchmark, investors must ensure that its strategic investment
implications are consistent with their needs. Five important strategic investment
preferences embedded in a benchmark are:
2 Interest rate risk profile: duration and term structure
Duration and term structure play a key role in benchmark selection and differ
significantly based on investor goals and needs. For instance, investors with long
duration liabilities, such as typical life insurance companies and pension plans, may
consider a long duration benchmark. On the other hand, investors with short to
intermediate duration liabilities, such as typical property and casualty insurance
companies, corporate cash investors and central banks, may consider a short to
intermediate duration benchmark. Sector allocation
The benchmarks specific sector allocation is driven by the investors risk/return
profile. For example, an investor seeking higher yields may select a more yield-
oriented benchmark with exposure to the corporate sector, providing credit
exposure, and to the mortgage sector, providing negative convexity exposure. A
conservative investor may exclude all sectors with lower than A-ratings, while a
more aggressive investor may include a high yield allocation in the benchmark. Security-specific risk
The benchmarks sector allocation creates security-specific risk implications, as every
sector comprises individual underlying securities. When markets are less volatile,
this risk is often overlooked and simply viewed as a consequence of the sector
allocation decision. However, in turbulent environments, it becomes more
prominent. This is especially true for corporate securities. Indeed, given the volatility
of this most recent credit cycle, investors have become increasingly concerned with
a large issuer exposure of any kind and have begun paying closer attention to the
individual underlying issuer benchmark weights and their strategic implications.
Exhibit 1: Largest Issuers in the Lehman Brothers Aggregate Bond Index (7/31/03)
Issuer
Weight (%)
Composite Rating
Ford
0.7
BBB
GE
0.7
AAA
Citigroup
0.6
AA
General Motors
0.6
BBB
Verizon
0.4
A
Source: Lehman Brothers
Perspectives | Sector Neutral Benchmarks: An Attractive Alternative to Traditional Benchmarks
The benchmark helps identify
the investors strategic
preferences, such as: Interest rate risk profile Sector allocation Security-specific risk Currency exposure Convexity
2
Typically, a benchmark does not communicate the amount of active management risk the investor wishes to take.
The investor will wish to instruct the portfolio manager as to how conservatively or aggressively to manage the
portfolio relative to the benchmark. This instruction should be included in the investment policy statement and is
typically quantified as tracking error (annual expected volatility of portfolio results relative to benchmark). Goldman Sachs Asset Management | 4
Perspectives | Sector Neutral Benchmarks: An Attractive Alternative to Traditional Benchmarks Currency exposure
The currency composition of the benchmark is usually driven by the underlying
liabilities of the investor. For instance, a small local company, which holds cash to
meet its payroll, will typically make investments denominated in the local currency.
However, a global insurance company with liabilities in multiple currencies may
adopt a benchmark with exposure to multiple currencies. The weighting of these
currencies in the benchmark is thus driven by the liability profile. Convexity
The amount of negative convexity in a benchmark normally reflects the investors
risk/return profile. As detailed previously in Sector Allocation, an investor seeking
more yield will often incorporate negatively convex sectors, typically mortgages, into
their benchmark. However, some investors will also consider the nature of their
liabilities when deciding whether to include negatively convex sectors in their
benchmark. For instance, if the liabilities of an insurance company are sensitive to
interest rates due to embedded policy options (options that would be exercised
against the insurance company), then they may be more cautious about
incorporating negative convexity into the asset benchmark.
Impact on Investment Decisions
The benchmarks potential impact on the portfolio managers investment decisions
reinforces its strategic importance. The benchmark generally serves as a neutral position
for a manager. In the absence of an investment view, a manager will often gravitate
toward a risk profile similar to that of the benchmark because it reduces the volatility
of the portfolios excess return, which is one metric by which the manager is often
evaluated. This behavior is not surprising, as a portfolio manager will only wish to take
incremental risk relative to the benchmark if he expects to be rewarded for it.
When a manager has a specific investment view, he will implement it relative to the
benchmark. For instance, if a manager believes interest rates will fall, he will hold a
long duration position relative to the benchmark. If the benchmarks duration is four
years and the manager is bullish on interest rates, he may target a duration of five years
(the benchmark duration of four years plus a deviation from the benchmark of one
year). The four-year benchmark duration represents the risk embedded in the
benchmark, and the additional one-year duration deviation represents the risk
associated with the managers active investment decision.
This simple example illustrates how a portfolios risk ca