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What’s that UBS bond benchmark in the annual statements?

Fund managers are currently sending out annual statements to their investors, including information on how their funds have performed. Typically, the fixed interest returns will be compared with something called the ‘UBS Composite Bond Index’.

However, many investors don’t know what that index actually means, or how it came to be the standard for comparing funds. During my years as a fixed interest fund manager, I was often asked to explain the nature and origin of this mysterious benchmark.

So who or what is ‘UBS’?

The history starts with the venerable merchant bank Dominguez Barry Samuel Montague (DBSM). The UBS indices are simply the modern version of the DBSM bond indices. Through the 1990s the firm changed its name many times, and so did the suite of bond indices that it maintained.  Most of the names had SBC in them, which became UBS in 1998 when the Union Bank of Switzerland took over Swiss Bank Corporation.

A legitimate question is whether this gives UBS Asset Management any sort of unfair advantage in managing bond funds. The answer is definitely no. I can say this with confidence, having worked with them from 1993-96 and also from understanding how the bond index calculation process works. The indices have been maintained for many years now by the capital markets and broking side of the business, which deals with all fund managers in the market. UBS Asset Management has no influence over the valuations used for any of the bonds in the index or the performance of the index.

The meaning of composite unravelled

What about the use of the word ‘composite’ in the name of the index?

The index is made up of bonds in the market, not just an index of Commonwealth government securities (CGS). It includes debt issued by a wide variety of issuers, including state government authorities, local companies and foreign entities that choose to raise money in Australian dollars.

That’s the simple answer. But the more detailed explanation of why an index like this was produced needs a short history lesson in Commonwealth-state financial relations.

Prior to the mid-1980s the only bond market of any substance in Australia was for CGS.  Apart from state government utilities like the NSW Electricity Commission, the Commonwealth undertook all borrowing on behalf of the states and on-lent the proceeds to them.

Then, at the Loan Council meeting in 1984, a package of measures was introduced to bring greater national control over the level of public sector borrowing. All borrowing by state entities was brought under the Loan Council oversight and limits for total annual borrowing by the states were determined. Under this global approach, the states would now borrow for themselves and on-lend to their own departments and agencies.

This led to the establishment of the state Treasury corporations to undertake the borrowing and to manage the internal lending to the various arms of government that needed funding. These institutions are what we now know as the semi-government authorities (or ‘semis’ for short).

At this point, Dominguez Barry entered the picture. Merchant bankers Jim Dominguez and Rob Barry saw the opportunity for their investment bank to help the semis get established, to originate and to market their debt securities and to encourage the development of this new bond market in Australia. (UBS is still a leading firm in the semi-government market.)

As part of the strategy they established a funds management business to invest in a portfolio that would include semis as well as CGS, and they needed a performance benchmark that was a composite of these two sectors.

As the market has evolved, with new issuers coming along, the index has also developed. It is now a composite of four sectors, each of which has its own index for performance and analysis purposes. The sectors are:

  1. UBS Treasury Index, which is CGS only
  2. UBS Semi-government Index
  3. UBS Credit Index, which includes investment grade corporate bonds
  4. UBS Supra/Sovereign index, which includes supranational issuers like World Bank and other Government guaranteed bonds.

Returns beat the benchmark

The fund manager statements that are now being sent out will show that the return from the UBS Composite Bond Index in 2013 was 1.99%. Individual fixed interest funds will be compared with this benchmark return and some explanation given for the relative performance.

Most fixed interest funds did quite well in 2013 and outperformed the Composite. This was mostly because almost all active managers were underweight in Commonwealth bonds and overweight in semis and corporates. The UBS semi-government index returned 2.52% in the year, and the UBS Credit index delivered 4.32%, compared with the Treasury index return of only 0.27%.

Another factor for managers who outperformed in 2013 is most likely a short duration strategy. Because this was a year in which yields rose, longer duration bond returns were reduced by the decline in capital value that goes with higher yields in the short term. Within the UBS Composite, the zero to three year maturity component returned 3.4%, but the 10 year and longer component was -2.7%.

Although it’s not the only index used by Australian fixed interest fund managers, the UBS Composite is the most popular. It is a comprehensive benchmark including the full range of investment grade securities available in the local market; it has a track record back to the mid-1980s; and information about its performance is readily available to all professional fund managers.

It is the fixed interest world’s equivalent to the All Ordinaries or S&P/ASX 200 that are used to benchmark share fund performance. And it comes with a fascinating history.

 

Warren Bird was Co-Head of Global Fixed Interest and Credit at Colonial First State Global Asset Management. His roles now include consulting, serving as an External Member of the GESB Board Investment Committee and writing on fixed interest.

4 Comments
Warren Bird
February 05, 2014

Peter, thanks for the additional history. My understanding was that MLC effectively funded DBSM's funds management business with the mandate and was the first to use the Composite bond index. In the 1980's, MLC was one of the trend setting fund managers and this was certainly one of the trends they set!

Adam, you rightly point out that the Composite bond index isn't as widely used these days. I wasn't really writing about it from a point of view of defending it or justifying it, but simply because it is still used by a lot of funds.

The point you make could be a caveat emptor topic as there are many discussion points around the pros and cons of cash benchmarks versus bond benchmarks. I think that the 'fad' is to use cash benchmarks - it made sense in the mid-1990's for a while, but the long term investment reality is that you get paid to take duration risk and bonds beat cash over time. Investors in a fund that gets 1% over cash are getting a lower medium term return than investors in a fund that gets 1% over the Composite.

Comparing TD rates with bond returns is common, as you say, but brings hidden dangers that I think many retail investors haven't been aware of. I wrote about this in a cuffelinks article last year, here: http://cuffelinks.com.au/term-deposit-investors-did-not-understand-the-risk/

Peter Vann
February 01, 2014

Thanks Warren for providing some history to the establishment of DBSM Funds Management. Maybe I can fill in some history relating to the “birth” of the DBSM bond index from within the funds management group.

After the DBSM funds management division was established, the benchmark used for fixed interest portfolio performance was an index run by CBA treasury. It had, inter alia, a couple of major failings for funds managers; (1) it was only calculated weekly and hence couldn’t be used to accurately benchmark monthly portfolio performance and (2) the yields used to price the bonds often didn’t follow the movements of traded yields that the dealing desk of DBSM observed, in fact sometimes they were static. So the head of DBSM’s funds management division, Derek Condell, decided to solve this by producing a daily index using real live yields at which bonds traded. The Bank Bill index (with its simple and pragmatic construction of initially equally weighted bank bills maturing at weekly frequencies) and the Government Bond index (reflecting market cap weighting) were developed and then the others followed at various stages.

This was quite an undertaking back in the 80s and experts were called in from numerous fronts; index methodologies globally were researched (John Bowers, then at Towers Perrin), the computer and data systems were specified and developed (Leo Chessell, then at Syscorp and Gayle McKnight, internal IT analyst), the academic and actuarial assessment of the indexes were done by Greg Taylor, then at Mercer. I contacted Derek to verify my memory and he recalled that one of the first clients to ‘use’ the Bond Indexes was MLC, who mandated – with Russell Investments - over $300 million to DBSM to manage against the 5 to 8 year sector of the index.

Very importantly, Derek ensured that a book explaining the index calculation methodology was produced for the market (numerous internal staff including Stuart Piper contributed to writing it); I wonder if a copy of this book still exists? Derek contacted UBS 2 years ago to track it down, but it was not found. This upfront transparency was not necessarily the norm back then as it is today.

Shortly after, another investment bank decided to develop their own bond indexes
and some of the DBSM team thought, “copying is the best form of flattery”! Those other indexes died as the market only needed one set.

Adam Coughlan
January 31, 2014

Warren,

Thank-you for your explanation re the UBS Composite Bond Index. Given the number of real/absolute return fixed income funds (e.g Kapstream, Realm and Macquarie Income Opportunities) using cash benchmarks with considerable sector allocation flexibility, I question the relevance of the Composite as a benchmark going forward, especially in the retail part of our industry. Negative monthly returns whilst beating the index seems so old world and a source of frustration for investors. The real person's rate of return (TD's) is often referenced by investors when making investment decisions, how many times would they have referenced the UBS Composite Bond return before chosing where to invest? Are parts of the fixed interest sector struggling to keep up with the changing landscape or is it a fad and cyclical?

Regards
Adam Coughlan

David Bell
February 05, 2014

Adam - your comment is current and an interesting reflection of where the industry is at with fixed income. While more manager flexibility and a "cash +" return sounds good my concern is that many financial advisers use these funds the same way they use traditional benchmarked funds. Specifically benchmarked funds provided duration exposure which has historically performed well in difficult environments for equities. If the bond part of a diversified portfolio is now full of "cash +" flexible funds then there is no guarantee that they will provide this protection when it is most wanted. So in effect we are gaining some alpha potential but forgoing a portfolio protection function. Financial advisers should really consider this.

Cheers, David

 

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