Olli RehnWith the euro zone facing a fiscal deficit nightmare, passive bond investors have been forced to think hard about whether following a simple market cap-weighted benchmark is a good idea. Traditional bond indices have the biggest weighting to the largest borrower — so investors end up lending more money to those desperate to borrow it.

“Passive investing in a traditional sense in fixed income doesn’t make a lot of sense,” said Paul Abberley, CEO of Aviva Investors UK. “The market caps of equities broadly correlate with underlying economic growth but it doesn’t work that way with bonds. For example, you would have been steadily increasing your exposure to Greece as they borrowed more and more.”

To address this problem State Street Global Advisors recently launched an index weighted by fundamentals that uses financial and liquidity ratios to assess whether a company is using its debt wisely, and whether the turnover in the debt is compensated for by the return. Similarly, Lombard Odier Investment Managers (LOIM) has developed its own fundamentally weighted index for its Emerging Local Currencies and Bonds Fund.

This uses factors such as purchasing power-weighted GDP, gross debt to GDP ratio, and fiscal budget to ensure the bigger weights go to the healthier economies rather than the most indebted countries. When markets rally this fund will lag, but when markets dip the fund will fall less and should exhibit significantly less volatility overall, a spokesperson for LOIM said.

Passive giant Vanguard also recently announced a move to adopt float-adjusted benchmarks to ensure investors are tracking a benchmark that actually reflects the debt available to trade in the secondary market. “Non-float-adjusted indices misrepresent what is available in the investable universe,” said Didier Haenecour, fixed income manager, Vanguard Investments Europe. “The rest is locked away with institutions that have no intention of trading these bonds.”