The Bank of England’s rate cut last week, the US Federal Reserve’s dovish stone and the Bank of Japan’s hawkish stance might all feel like momentous events that will determine risks and opportunities for the rest of the year, not to mention the global equity market rout.
But the biggest event of 2024 for Legal & General Investment Management’s (LGIM) passive fixed income desk unfolded when Indian government bonds entered the JPMorgan Government Bond Emerging Markets index in July.
“In terms of index-risk events and for the materiality of the change of the universe, it's the biggest event we'll have on our desk this year and across all of the fixed-income asset classes,” said Lee Collins, who leads the desk.
Following the official announcement by JP Morgan in September, investors started adding money to Indian government bonds, with many using exchange-traded funds (ETFs) to do so. For that purpose, LGIM launched the L&G India INR Government Bond UCITS ETF, which swelled to £860m of assets under management.
Since the change to the index composition has gone live, $12bn has been moved into Indian debt in less than a month – more than half of the $20bn inflows that JP Morgan expected in 12 months.
At the start, inflows came from professional investors trying to get there first, such as active managers and hedge funds. Then the passive funds followed, as they are obliged to match their benchmark’s weighting.
“Some funds have the ability to move quicker than others and as we go through the remaining months of the index inclusion, the proportion of passive flows is probably going to be higher than the active funds,” Collins said.
Because passive strategies are often the last ones to move, Rob Brewis, manager of the Aubrey Global Emerging Markets Opportunities fund, advocated for investors to choose actively managed portfolios if they want to profit from moves as they happen.
That’s what he did with Indian equities when Narendra Modi first came to power 10 years ago. India only amounted to 7% of the MSCI Emerging Market index, but the manager’s weighting was around 25%.
“That it was likely to be a considerably higher weighting 10 years on was not a difficult leap to make at the time, given the progressive BJP government’s likely reforms, as well as the fundamental drivers of growth of a country at that stage of its development, as well as India’s sheer size,” Brewis said.
“Investing passively is like driving by the rearview mirror. An index gives you a very good idea of what has happened in the past, but it is not much help in predicting the future.”
Today, his weighting to Indian equities is closer to 50%, more than double the index.
This would never be possible by investing passively, because index funds cannot move materially away from their benchmark. For this reason, investors in the JPMorgan index won’t be getting more than the target allocation of 10% in Indian debt.
However, the cap is necessary to protect passive investors from getting too much exposure to the more indebted countries, Collins explained.
“China would take up about 40% of the index if it was market-cap weighted. Instead, it is capped at 10%. Similarly, India would be far above 10% if it was not capped,” he said.
“In an asset class like emerging market debt, you do tend to find people are more comfortable with a capped strategy that has a more diverse exposure rather than being heavily concentrated to one or two markets.”
Responding to Brewis’ argument against passive investing, Collins said that “there's a place for both” active and index approaches in all asset classes.
“Over the past decade, we've seen a huge growth in index assets and a large proportion has come from previously active allocations. There's been a general trend of money flowing into index from active and emerging market debt has not been immune to that.”
As for the next ‘big event’ of this nature for his desk, he pointed to Saudi Arabia as the possible next candidate for index inclusion, in addition to the Philippines, which is already in the benchmark but though dual currency, internationally-issued (not domestic) bonds, as well as South Korea and Kazakhstan.