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, © 2001 Investment Management Consultants Association Inc. Reprint with permission only. 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).