LEHMAN UNIVERSAL INDEX by Ronald]

CRITI DE OFT E LEHMAN UNIVERSAL INDEX By Ronald]. Ryan, CFA

A recognized authority on fixed income strategies reminds us that the uses of this popular composite are limited.

DISCLOSURE Corporate Bond Index was the initial benchnlark used by consultants and plall sponsors. I joined In the interest of full disclosure, I feel it proper Kuhn Loeb in 1977. At the end of that year, Kuhn to note that I was a former director of research for Loeb merged into Lehman, and the evolution of Lehman from 1977 to 1982. In that capacity, I bond indexes quickly developed. In 1979, as a designed the Government/Corporate Index plus project for CIGNA, I designed the Lehman numerous custom indexes. I am proud to have Goverllment/Corporate Index. I dedicated myself Lehman on nlY biography and will always be to a road show with consultants to inform them of grateful for the experience and knowledge this innovation and revelation. Shortly thereafter, afforded me there. the Lehman Government/Corporate Index became the generally accepted benchmark for bonds. GENESIS When Lehnlan introduced the Aggregate IIldex in 1986, it became the primary bond benchmark by The first bond index was designed ill the sunl the end of the decade. The new Lehman Universal mer of 1973 by Art Lipson, the director of research Index introduced in 1999 is now being promoted for Kuhn Loeb. Lipson actually created three dis as the replacement for the Aggregate Index. tinct indexes: 1. Kuhn Loeb Bond Index THE OBJECTIVE (All Corporates longer than 1 year) 2. Long-Term Corporates The objective of designing an index should be (All Corporates longer than 10 years) to provide accurate risk/reward measurements of a 3. Governnlent Index well-defined and distinct universe. If performed (Treasury plus Agencies) correctly, tliis data can become the foundation of Salomon delivered their bond indexes also that asset allocation, the benchmark for asset manage summer, and their Long-Term High-Quality ment and eventually purchasable as an index fund,

36 THE]OURNAL OF INVESTMENT CONSULTING futures or options contract, and exchange traded RULES BASED fund (ETF). A narrowly defined universe is pre ferred to relate to the expertise and style of asset Indexes are best choseli and used based upon management as well as the index data needed to their rules. The methodology of an index is rules implemen1 asset allocation models, style analysis, based. One chooses the S&P 500 or any index and performance measurement. Markets are too thinking it will exhibit a certain risk/reward behav vast today, especially in fixed income. Gone are the ior based upon its rules goverl1ing composition, days of a general practitioner; everybody today pricing, reinvestment, etc. Unfortunately, there is is a specialist. no regulatory body governing indexes. As critical The expertise, staff, and decision-nlaking to the American economy as indexes have becon1e, infrastructure needed to manage all bonds are it is amazing that there is no governing body that incollceivable except for a few very large firnls. supervises this development. It is primarily a mar The objective of the Lehman Universal Index is keting game. Most practitioTILers have little knowl to capture the entire fixed income market in U.S. edge of or experience in lio'N indexes are created dollars. The subsets of this index are in_deed an and maintained. In my five years at Lehman, not achievement and worthy of review as proper Olie persoli came to witness how we constructed benchlllarks. However, as a COlllposite ilidex, the and modified our indexes. Index providers have risk/reward results become obscure. If you dine at complete autonomy to do whatever they feel is a first-class restaurant and order their exquisite appropriate or profitable. PiS a result, rules are seveli-course meal, you wouldn't ask thenl to com decided by the index creator, alid rules change bine all seven COllrses as a casserole. You would sometimes often. The Lehman Universal rules (or end up with mush. You want to savor alid appreci lack thereoD are interesting alid quite flexible: ate each course. It would be hard to appraise the Rating: No restrictions (any rating) veal if it were cOlllbined witli the sorbet. Since Issuer: No restrictions most asset managers and consultants use the aver Country: No restrictions age statistics of a bond index to communicate a Minimum Issue: Variol1s (no standard) risk/reward profile, it is difficult for such a large Securities: Any U.S. pay bond except: bond casserole to communicate meaningful data. zero-coupons, municipals, Moreover, asset allocatio11 suffers if too broad an CMOs, converts, linked index is used as a benchmark. The more asset bonds, structured products classes you can define and measure, the better the Pricing: 95 perce11t Lehnlan traders model. Intraequity allocation has certainly In 1986, at the Battle of Bond Indexes seminar, reflected these considerations. I delivered nlY draft "Constitution" on Index Rules. The stock market is a relevant case study I proposed that for any bond index to be Equity practitioners use narrowly defined indexes accepted as a benchmark it must conform to the that measure a unique risk/reward area. They don't following rules: merge the S&P indexes for large, mid and small cap. They want to measure style and strategies 1. Composition indepel1dently Only the bond market has gone To become a belichnlark, a bond illdex must astray The basic reason for this is that the bond be transparent with regard to its portfolio C01i indexes used are created by Wall Street investment struction so the world can easily understand what baliking firms that have a vested interest in includ conlprises it on a regular basis. There should be no ing all their clients' issues in their indexes. Without charge for such data; it is the cost to qualify as a proper filters for composition, liqUidity, and pric benchmark. ing, adding more issues to an index usually creates Lehman does a fine job in providing usefll1 statis more pricing problems, more confusion, and less tics on all their indexes. However, to my knowledge, liquidity while providing greater profit opportuni there is a fee to see the actual portfolio and prices. ties for Wall Street. Continued on page 38

© 2001 Investment Management Consultants Association Inc. Reprint with permission only. VOL. 3, NO.2, JUNE 2001 37 Continued from page 37 4. Weighting 2. Frequency How you weight an index skews the Trends don't wait until the end of a month to risk/reward data accordingly To be market-weighted happen. As a benchmark, daily data are needed and a daily bond index, you need to know the with a consistent closing time. Lehman qualifies amount outstanding of every issue in the illdex here with daily frequency and a consistent every day Amount outstandings are difficult data closing price. to ascertain in bonds because government securi ties get stripped, corporates get sunk, and mort 3. Pricing gages get prepaid. Moreover, all such data are Any bond index benchmark must be transpar reported delinquently, if at all. Returns should be ent on its pricing such that the world can easily price-dependent, not weight-dependent. If SUCll understand how the risk/reward calculations were data are not clear, tllen an unweighted (equal made. Moreover, such pricing must be real weighted) index is required. market prices that are tradable. This would facili A serious problem with Lehman and all broad tate transacting index funds, exchange based indexes is their weights. It is impossible to traded funds, futures and options contracts, etc. know the amount outstanding per issue daily, If issues are not monthly, or at any time. Government zero-coupon tradable at such securities are NOT in the Lehman bOlld indexes. prices, we are All Treasuries and Agencies that have been If you dine dealing with hypo stripped are overweighted in the Lehman indexes thetical pricing since they use the original amount outstanding at a first-class causing the (before stripping) and not the currellt an10unt out risk/reward calcu standing. Mortgage-backed securities have grown restaurant and lations to be ques in market share in all the Lehman broad irldexes. tionable. Any Their principal outstandillg is inaccurate since order their exquisite benchmark index Lehman takes the last reported principal and inter must be pur est payment as applicable to tIle Cllrrellt month seven-course meal, chasable or it is not although it may have been for a period one to two real and should months earlier. The risk/reward error tends to be you wouldn't ask not qualify as a slight but consistent and adds up over time. proper standard. Another problem is that the index statistics them to combine Lehman and Lehman publishes are market weighted except for any broad-based average price alld coupon that are par weighted. all seven courses bond index would This inconsistellcy hinders any replication tech have great diffi niques that try to match index averages. If zeroes as a casserole. culty in capturing were included, tlley would skew the par-weigllted real prices daily. averages rather significantly You would end up Most bonds do not trade actively. In 5. Reinvestment with mUSh. the case of mort Over time, reinvestment becon1es a signifi gage-backed secu cantly greater component of the cumulative total rities, Lehman uses return of a bOlld index (Reinvestment return =: generic hypothetical issues that cannot be 75.6 percent of the Lehman Government/C=redit purchased since tlley are not real securities. and 73.2 percent of the Lehman Aggregate since This is commonplace for all broad-based inception). By definition, an index can only own" fixed illcome indexes due to the what it is. It cannot own cash if its methodology massive number of mortgage pools (estimated at does not allow such investments. Moreover, any one million). interest income or prinCipal repayments must be

© 2001 Investment Management Consultants Association Inc. Reprint with permission only. 38 THE]OURNAL OF INVESTMENT CONSULTING reinvested when received. A bond index cannot (www.ryanindex.com). is equally weighted (no have idle or unused funds (reinvestment rate weighting problem), reinvests at the total return of zero percent) waiting until month end for rate of the index, is widely distributed by periodi reinvestment. cals, and is certainly the most transparent and pur Unfortunatel~ these are common problems chasable bond index available today in the world. with most broad indexes (except Merrill Lynch) Well-defined indexes are critical; narrowly an.d certainly all the Lehman indexes. Lehman uses defined indexes are always best. This is certainly a no-reinvestment metl10dology until month end. not the case with the Lehman Universal Index. It is This means an implied rate of zero percent on all hard to understand any index without strict rules, reinvestment proceeds during the month. A zero restrictions, a11d standards. The Lehman Universal percent rate is not indicative of reality, and over lacks discipline. With over nine thousand issues time will distort the true risk/reward characteristics worldwide, it is an impossible index to price accu of a11Y Lehman index. rately-or buy-or even understand as a compos ite. But there are other considerations. 6. Accessibility Any bond index benchmark must make every ASSET ALLOCATION attempt to deliver data universally in a fee-friendly way (free). Websites, periodicals, and financial net Asset allocation is the initial and key decision works should all be used and encouraged. Such any investor should make. Asset allocation models delivery must be daily and soon after the index try to answer the questions, What markets should close to be considered a benchn1ark. I buy? and How much in each asset class? The data Lehman does a fine job in making all their of these models are 100 percent pure in.dex data index data accessible. arrayed as the proxy for each market or asset class. Ryan Labs has lived by all these guidelines as Index data are the fuel of asset allocation, such that the Ryan Index (Treasury yield curve) was the first the better the data, the more efficiently the model daily bon.d index (1983), has its own website Continued on page 40

Exhibit 1 PIPER (as of 12/31/00) Last 10 years Last 5 years Last 3 years

Median Equity 18.2 17.9 12.6 S&P 500 17.4 18.3 12.3 BP Difference 440 -220 240 Percent Difference 4.4 -2.2 2.4

Median Bond 8.4 6.6 6.4 Lehman Aggregate 8.0 6.5 6.4 BP Difference 40 10 a Percent Difference 0.4 0.1 0.0

© 2001 Investment Management Consultants Association Inc. Reprint with permission only. VOL. 3, NO. 2, JUNE 2001 39 Continued from page 39 chase is the minimum requirement for an institu will perform. Asset allocation models prefer, if not tional round lot, one would need a $6 billion to $9 require, narrowly defined asset classes. The equity billion portfolio to invest in these indexes. But that market does not use one all-inclusive index, but a orily works if the il1dex is equal weighted. Because series arranged by style, capitalization, industry; these indexes are market weighted, then if the geography; etc. smallest position is $1 million, it would take a The pioneering study by Brinson, Beebower portfolio size well above $100 billion to purchase and Horn showed us that asset allocation accounts a market-weighted broad index. for approximately 90 percent of the total return of an average client. Ryan Labs research would sug SYSTEMATIC RISK gest it is even higher. According to performance measurement studies, e.g., Pension & Investments' Style analysis has become quite popular (PIPER), the median institution.al manager adds lit mainly due to the work of William Sharpe. His tle value over the index benchmark. (See Exhibit 1.) concept was to isolate and explain tl1e return dif As the PIPER study consistently proves, the ference of a portfolio versus the index benchmark index bench.mark represents between 95 percent by style (market risk or systematic risk) and issue and 102 percent selection (nonmarket risk). Style analysis reveals of the average quite succinctly that market risk dominates in (median) return bonds. To be clear, the n1arket risk in bonds is critical to before fees. For "interest-rate risk." Unless you measure interest As rate risk, you are not measuring style and your such nominal the American value added, one model is incomplete or faulty For style analysis to would think that function, it must have an array of indexes that iso economy as indexes index funds late and explain market risk. The equity market should be the core measures n1arket risk by capitalization, geography, have become, it is or primary invest industry; etc. On the bond side, market risk is ment style, espe clearly interest-rate risk (yield curves). amazing that there is cially in bonds A consistent problem with broad bond indexes where the basis is they fail to subdivide their data into a proper no governing body point difference yield curve index series. Without an accurate yield between the median curve data series, you cannot measure interest rate that supervises manager and the risk. A yield curve is defined by the Treasury auc Lehn1an Aggregate tion process and what ranges of bond maturities this development. Index is negligible are priced off these few key issues. Lehman does (before fees). well to isolate and measure "excess returns" It is primarily a Accordingly; if defined as the return above the Treasury yield index funds are a curve. Given this ack110wledgement that the true marketing ga.me. meaningful style of value added (intrinsic value) of any bond is its investing, then th.e return above the key Treasury issue with a similar index benchmark maturity or duration, it follows that this is the way 11ad better be pur you design or model your index. Lehman subdivides chasable. This is the U11iversal I11dex by a rather stra11ge yield curve: difficult with the broad bond indexes and impossi 1-3 years ble with the Lehma11 Universal. With six thousand 3-5 years to nine thousand issues in these indexes, even if all 5-7 years these bonds could be purchased it would take a 7-10 years massive portfolio to invest in all the issues without incurring huge trading costs. If a $1 million pur 10+ years

© 2001 Investment Management Consultants Association Inc. Reprint with permission only. 40 THE]OURNAL OF INVESTMENT CONSULTING Treasury issue is in the five Exhibit 2 to seven-year cell. The Correlation of Monthly Returns Lehman. Universal Index (1979-1987) yield curve configuration RYAN Lehman ML Salomon needs to be reworked. Without a yield curve RYAN Index 0.984 0.985 0.986 index series, interest rate risk Lehman GovtlCorporate 0.984 0.997 0.997 cannot be n1easured, value added (alpha) cannot be ML Domestic Master 0.985 0.997 0.997 n1easured, and style analysis Salomon BIG 0.986 0.997 0.997 models cannot calculate the return from style (il1terest-rate risk). All the Lehman bond indexes fail to qualify here. Exhibit 3 RISK/REWARD Correlation of Monthly Returns 10 years 7 years 5 years 3 years The risk/reward of the U.S. bond n1arket is h.ighly RYAN Index versus interest-rate risk dependent. Lehman Aggregate 0.9644 0.9583 0.9444 0.9105 The Notre Dame study of bond indexes in 1987 proved this claim. It showed that 96 to 99 percent of the broad It is hard to understand excess returns above bond index retur11S came from interest-rate risk the Treasury yield curve if your yield curve doesn't measured by the Treasury Yield Curve (RYAN match the Treasury term structure. How would Index). (See Exhibit 2.) you calculate the alpha of a 10.5-year security and As shown, all broad indexes demonstrated a a 30-year security? Aren't they two distinct spots correlation of monthly returns to the RYAN Index on the Treasury curve with significantly different of 0.98 providil1g proof that the Treasury yield durations and yields? Yet the Lehman Universal curve explains or exhibits over 96 percent of the Index methodology would have t11em in the same returns of these massive bond portfolios. Ryan cell. The one- and two-year Treasuries would also Labs updates this data monthly After serious dis be in the same cell? I don't know what key ruptions to the Treasury yield curve since 1987 (removing the three-, four-, and seven-year auctions), the correlations as of 1/31/01 are shown Exhibit 4 in Exhibit 3. PIPER The RYAN Index is an equal-weig11ted il1dex. (Fixed Income versus Broad Indexes) Weighting the Treasury yield curve to match the term structure of the Lehman Aggregate would Last Last Last raise these correlations even higher. 10 years 5 years 3 years 1st Quartile 8.9 6.9 6.7 PRICING

Median 8.4 6.6 6.4 The curse of the bond market is that there is Difference 0.5 0.3 0.3 no bond exc11ange. As a result, the pricing of most Continued on page 42

© 2001 Investment Management Consultants Association Inc. Reprint with permission only. VOL. 3, NO. 2, JUNE 2001 41 Continued from page 41 with a similar maturity or duration, then all bond bonds is suspect. Given that the spread between sectors should be compared or nlanaged versus the first quartile and median asset management per Treasury yield curve. That was the logic behind the formance (via PIPER) is less than 50 basis points a creation of the RYAN Index as the first daily bond year, a pricing discrepancy of just 1/32 a month index ill MarcIl 1983. If you can't olltperform the (3.1 basis points) could be critical in performance Treasury yield curve, what is your value? Lehman measurement. (See Exhibit 4.) and I agree: it would be a negative value. As we What is needed is a central price or bond have moved to a duration-based bond market, exchange. Without it, bond pricing is a dangerous then the base rate to conlpare all bonds would be business with serious risk/reward consequences. the Treasury STRIP curve. This also fits liability All indexes should use the same price. Those driven objectives since the government zero prices sl10uld come from a ll01lindex creator to coupon yield curve is the base rate for pricing avoid any biases. Naturally, the larger the index liabilities. Given a target duration (risk profile), (number of issues) and the broader in scope, tIle any bond manager could be compared to the greater the pricing difficulty and tracking devia STRIP Index with that target average duration for tions. How many bonds do you need to nleasure value added (i.e., alpha). the risk/reward of a sector? As few key issues as possible. Addin.g more issues hin.ders the ability of 3. Baseline Portfolio Construction an index to properly calculate accurate risk/reward The Baseline Portfolio concept developed by behavior patterns. Marty Leibowitz of Salomon in the 1970s was adopted by New York City pensions, but Lerlman SOLUTION(S) was the system. A series of sector indexes was weighted by the client and its consultant to ach.ieve 1. Custom Objective Index the proper benchmark. Specialty asset managers The index that best represents tb.e client objec were hired to manage just Governments--just tives and rules is the most appropriate benchmark. Corporates-just Mortgages. Each manager was For liability-driven objectives (e.g., pensions, given a toleran.ce of plus or minus around the sec insurance products, lotteries, NDT, etc.), it is obvi tor index. At any time the client could adjust the ous that no generic index matches the objective(s). weights to fit the desired asset allocation target. Only a Custom Liability Index could be the solu This solved the problem of broad bond index com tion. Having the wrong index as the objective is the position drifts and redefinitions while it allowed most critical mistake tllat could be made and may the client to hire more expertise (more asset lnan be the biggest problem facing financial America agers) rather than award few managers large asset today As Lehman states so clearly in its sunlmary allocations. In our age of specialization, hiring 011 the Universal Index: "In our view, the selection bond managers for a particular sector Gust like of an appropriate bond benchmark best suited to equities) would provide flexibility, diversificatioll, portfolio objectives and constraints should be and better value added. undertaken by the trio of plan sponsors, consult ants, and bond managers." Confucius In. the en.d, I look to the great philosopher 2. Treasury Yield Curve Confucius who once said, "Given the Since the intrinsic value (alpha) of any bond is wrong index... the wrong risk/reward will its "excess return" above the key Treasury issue eventually happen."