Focus on smart beta – A fundamentally weighted approach protects investors from credit risk

If you are in the business of lending money, how would you feel about lending more to the customers who have borrowed the most?

This is the question asked by Stephane Monier (pictured), co-deputy chief investment officer at Lombard Odier Investment Managers, to open the debate on fundamental weighted benchmark, equity indeces in which components are chosen based on fundamental criteria and to which the firm expects strong flows.

“Not keen, probably. But that is what most investors in Eurozone government bonds have been doing,” he says.

Most benchmarks, whether applied to an equity or bond universe, use a market capitalization methodology, Monier explains.

Instead, a fundamentally weighted approach applied to a bond universe ensures investors favour the issuers with the greatest capacity to meet their obligations as it focuses on their credit metrics.

Moreover, with the creditworthiness of so many countries under the spotlight, investors are re-assessing the methodologies driving their benchmark allocations.

“Going forward we see the biggest risks coming from Market-Cap government bond indices where the aggregate market-cap allocation to the US, Japan and Italy form more than 60% of the benchmark,” says Monier.

Fundamental weight driven allocations are a sophisticated measure of an issuer’s ability to meet its obligations.
The approach looks at factors including macroeconomic measures, forward looking obligations on the issuer and socio-economic issues.

“We start with the size of a country’s GDP as the likelihood of a larger country defaulting is less than that of a smaller country. GDP Growth is also assessed since a country that is growing faster will have more ability to generate the tax receipts to service its debt,” the manager says.

Countries with a significant debt burden in the public or private sector have their weightings reduced which is exactly to the contrary of what a market-cap methodology promotes.

Foreign net ownership of debt needs to be watched since countries that receive a significant amount of funding from foreign investors are at greater risk of capital flight.
They also receive a reduced weighting.

Similarly, countries with lax fiscal discipline and poor budgets will require more debt to fund deficits and therefore receive a lower weighting in the index. In contrast countries with current account surpluses receive a higher weighting as they are either competitive in global trade or are able to attract foreign capital, in both cases improving a country’s ability to repay its debt.

Socio-economic issues such as an ageing population are a challenge for governments in the future and will impact health and pension spending. Countries facing more difficult circumstances are allocated a lower weighting.

This includes those with higher political risk where governments are battling high inflation or high unemployment and will be limited in their ability to make significant economic changes.

“We also believe a fundamentally weighted approach makes a great deal of sense when applied to a corporate bond universe. The objective is the same because the fundamental approach measures an issuer’s ability to meet its obligations, but is looking at a different set of fundamental factors,” says Monier.

Sector-specific factors assess that industry’s contribution to national or regional GDP, a process which ensures investors are allocated to the real economy and not following asset bubbles. Within each sector, issuers are weighted using specific factors which include turnover, leverage, interest cover, free cash-flow and the growth rate of earnings compared with the growth rate of net debt.

“As investors turn their attention to the underlying methodologies of their benchmarks, it makes sense to lend more money to the issuers most likely to pay their obligations. In an environment in which burden sharing for bondholders is increasing investors’ vigilance, we are expecting fundamental benchmarking to gain considerable momentum,” he says.


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