Broad-based approach: Here’s how it differs from liquidity-based approach; benefits investors

The largest fixed income indices across the world are constructed using the Broad Based approach

By Anand Nevatia

An index tries to measure the returns generated by a defined asset class, by taking multiple securities which represent some aspects of the total. An index provider may employ various principles and criteria for choosing the securities in an index.

The fixed income indices in India are mostly Liquidity Based i.e. the indices are calculated basis the recent liquidity of the issuers. Thus, if an issuer has witnessed a high primary or secondary market volume in a quarter, they get preference in terms of inclusion and weightage, in the subsequent rebalancing of the index.

As a result of this approach, the index could see a lot of churn in the constituent securities on every rebalancing due to a change in the liquidity profile of the issuers. Fund managers who follow the benchmark allocations would have to trade more, leading to increased transaction costs to the fund, thereby impacting its returns. Another drawback could be in a situation wherein a new issuer is able to find large weightage in the index based on activity based parameters. Liquidity could easily dry up in an untested new issuer, thereby forcing all index funds to liquidate in an illiquid market.

The largest fixed income indices across the world are not subject to these inefficiencies, as they are constructed using the Broad-Based approach. These indices take into account the total outstanding issuance amount of the issuers, i.e. higher the amount outstanding, the higher will be the weightage.

The Broad-based approach has certain key advantages over the Liquidity Based approach:

Characteristics

– More accurate representation of the underlying universe
– Relatively lower churn
– Inherently liquid portfolio

Benefit to Investors

– Returns are more commensurate to the underlying asset class
– reduces transaction and impact costs thus leading to higher returns
– Mitigates liquidity risk over a period of time

Below are a few examples of large fixed income indices that follow the Broad-Based Concept

Large fixed income indices that follow the Broad-based concept

A key part of the investment process is the Model Portfolio which is constructed based on the Broad-based approach. The model portfolio is constructed in two stages:

1. Category allocation: The sector weights are assigned basis their total outstanding. For example, say PSU Financial Institutions category has 20% of the total outstanding so in the initial composition the weightage is set to 20%.

2. Issuer allocation: Within categories, weights are then assigned to individual issuers basis their total outstanding issuance amount

The weights to categories and issuers are then adjusted for regulatory compliances. Thereafter, periodically the model portfolio is rebalanced to take into account any changes in the underlying universe.

The aim of adopting a broad-based approach in fixed income investing is to provide investors consistent risk adjusted returns that are commensurate to the underlying asset class through a structured and transparent investment process.

(Anand Nevatia is Fund Manager at Trust AMC. Views expressed are the author’s own.)