Listen: The Essential Podcast, Episode 99: The Hare and The Tortoise; Tim Edwards and Passive Bonds Potential

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Nathan Hunt: This is The Essential Podcast from S&P Global. My name is Nathan Hunt. Indexing is big business. This makes a lot of active investors nervous. This makes a kind of sense. If more people chose to invest passively, it might make it hard to collect your fees. Well, passive investing has become more popular in equity markets over the years. The place active investors felt safe and protected was fixed income markets. After all, bond markets are far too large and complex to ever be indexed effectively. Or so we have been led to believe.

I'm joined today by Tim Edwards, Managing Director of the Index Investment Strategy Group at S&P Dow Jones Indices. I suspect Tim has some bad news for active investors about fixed income markets and indexing. Let's hope the news isn't all bad. Tim, welcome to the podcast.

Tim Edwards: Thanks for having me, Nathan.

Nathan Hunt: Tim, I'm afraid we need to start with a rather basic question just to level set for our listeners. A lot of people think that creating an index is a simple process of just grab the top 30 or perhaps the top 500 biggest companies in the world and say, here's my group. Judging by the fact that you have a PhD in mathematics from University College London, I'm going to guess that there's a little bit more that goes into this. Can you talk a little bit about that?

Tim Edwards: Yes, certainly. So first of all, it is actually not that complicated to create any index or certainly to create some indices. In fact, the first recognized index of the markets was an equity index, and it was launched over 125 years ago by a gentleman called Charles Dow who would go on to found the Wall Street Journal and whose surname is still there in the name of the company, S&P Dow Jones Indices.

And it's still famous today as an index, the Dow. The Dow, its full name the Dow Jones Industrial Average, and actually, that you can calculate, you don't even need a slide rule. You just -- it's 30 stocks and you add up all their prices and you see how that evolves from day to day. And the reason that Charles Dow started doing that was because he wanted a simple way to describe not how one or another part of the market was doing but how the overall market was doing. And he wanted to condense it down into a single number.

Now indices have evolved considerably through the -- nearly say centuries, but in the 130-odd years since, other important milestones to notice. 1957 was when indexing went digital. Another of the brands in our stable, if you like, that was when the S&P 500 was created in its current form. And what was exciting about that wasn't the fact that it was 500 rather than 30 stocks. They did have more complicated calculators by then, but it was that it published every 15 seconds so you could watch the market intraday.

Now that's still a good -- well, many decades ago. Since then, the notion of indexing has extended to beyond just fixed numbers of stocks or fixed numbers of U.S. stocks but to a very diverse range of different indices, some of which are a bit more sophisticated. I mean, I'll give you the example of something like VIX, which is essentially a measure of how expensive options are. That's a very sophisticated index, and you probably do need, if not a PhD in mathematics, then at least a bit of calculus to understand how that's built.

We're going to talk today about our fixed income indices. They do have a more recent history. They're not as old. They tend to be a lot broader. The fixed income markets are a lot more granular. And they do take quite a bit more careful care in building, maintaining an ongoing calculation.

Nathan Hunt: So as you say, a lot of my questions today are going to be about an article that you co-wrote that can be found on the S&P Dow Jones Indices website, and it's called The Hare and the Tortoise - Assessing Passive’s Potential in Bonds. Using your analogy from the fable, who is the hare here and who is the tortoise?

Tim Edwards: Yes, we did call it The Hare and the Tortoise and there's not a single one-to-one correspondence. I think that was one of the reasons I chose that title. There's actually, if you like, 2 hares and 2 tortoises. In one sense, the equity markets are the hare. They're exciting, they're glamorous. People make and lose fortunes every day. The markets are -- the equity markets are far more excitingly and enthusiastically followed by the media.

And the tortoise is the sort of bloody old, careful, watch my yield, careful with my credit fixed income markets. But there's another sense that I was playing on in which the stock pickers, the bond pickers, the masters of Wall Street, they're the hares. They are the ones who are racing ahead with their fast feet and maybe with a little bit more showy, maybe a little bit more complacent.

And the bloody old index funds represent the tortoise. Eyes fixed on a long-term goal, thinking about things like diversification and cost management, very tortoise-y approaches. But one which as in the story, the evidence suggests may, in the long term, deliver surprising results.

Nathan Hunt: Excellent. Passive investing is well established in equity markets. What is it about fixed income markets that makes passive investing more challenging?

Tim Edwards: There's actually -- there's a few different reasons. I guess I'll try and summarize them. And then if you like, we can dig down a little deeper in any one of these different dimensions. The first and probably the most important, we've already touched on it, is that indexing or passive approaches to the bond markets are much more difficult to implement.

So we talked about the S&P 500. That's 500 companies. It's actually 503 shares because some of the companies have got dual listings. So you've got 2 shares you've got to buy to get the whole company. But just 500 securities covers between, over time, historically, between 2/3, 3/4 of the total U.S. equity market. The average price to buy one of those shares is around $200. You can pretty much replicate that portfolio perfectly or very close to perfectly without a vast amount of capital.

Just to give you one comparison, right? So those same 500 companies that make up the S&P 500, if you wanted to capture all the debt or fixed income securities that was issued by those companies, you would need a portfolio comprising over 6,000 distinct securities. And not only that, they have an average maturity of between -- I mean, it varies over time, but around 5, 5-and-a-bit years. So 20% of your portfolio is maturing every year. Things are getting upgraded or downgraded through investment grade. There's new bonds issuing all the time.

And they don't all cost just $200. Some bonds are lumpy. And so immediately, you can see that in order to even think about replicating a broad market fixed income index, you're going to need, well, first of all, probably a bit more capital. Second of all, you're going to need some degree of sampling or some sophisticated strategies to say, okay, how can I replicate the performance without only one of everything? So that's one piece, just the practical difficulty.

That's probably the most important reason why it came later. There are other reasons which are really more to do with, I guess the investment case rather than, can I do it? And then if I can do it, why would I do it or not? And I think there are several -- we used the word theological in the paper because I think some of these are -- it's almost a theological opinion that suggests that, well, the equity markets, they're very efficient. They're very fast. I see why indexing will work there, but the bond markets are different.

The value of credit selection, the value of actively managing in the bond markets is much, much higher. And I think -- I expect we'll go into 1 or 2 of those aspects, but this, I think, is where the allegory between the hare and the tortoise really comes through because it looks like that might be the case, and there are some good common sense arguments why you might think that indexing or passive investing is a foolish approach in the bond markets, but the long-term evidence suggests that actually, it's not only outcomes achieved by index funds have been such as to put them among the very highest of performers in relative terms.

Nathan Hunt: Okay. Well, let's dive into one of those. You talk about the challenge of replication, right? This is something that is, of course, increasingly complex in equity markets. But when it comes to bond markets, as you say, we're talking about 6,000 different assets. They are lumpy. How do you even begin to replicate bond markets with an index? Like what is the mechanism that is used to accomplish that?

Tim Edwards: Well, look, and this is something where we, as an index provider, can acknowledge the expertise of the asset managers who then have the task of replicating that index. There are some things that an index provider could do. For example, narrowing the universe perhaps to only more liquid, only investment-grade, only U.S. dollar-denominated securities. And then so you can sort of define the universe a little bit more carefully and in a representative way, of course.

But there are S&P 500 companies that are high yield or that are issuing bonds in nondollar currencies. So there's one sense which the index can evolve to meet the needs of an investment rather than just a total market capture. Then from a replication perspective and then again, this is the expertise of the index fund manager or the portfolio manager, there are certain well-established approaches.

The first is, to a large degree, a bond portfolio will be -- the performance of a bond portfolio will be determined by the credit quality or the average credit quality, the duration profile, the sectoral profile, the degree of diversification and other things that we've already established like currency. So you can see how at least the problem is addressable in practice and what we included in the paper was a sort of ex post "Okay, well, how did they do?"

We picked -- sort of for good reason, we picked a few first movers in this space, right? So the first ever bond index fund was introduced in 1986. It took another -- was it 14 -- 16 years, sorry, for the next tranche when you got investment-grade and high-yield bonds, bond indices launched in ETF for U.S. dollars. And then a few years later, with the final one coming in 2010, you also had euro investment grade and high-yield bond universes replicated by index funds or ETFs in some cases.

So you have these, okay, well, over their whole life, we've got a decent 10-plus years or 15 or even back to 1986. How did these index tracking or putatively index tracking funds do as compared to their index? And there, the data is pretty compelling that over decades, through, for example, sort of sampling approaches, through also being able to attract more assets to cover more of the index, these funds were largely able to replicate the indices that they were designed to track.

However, and we do highlight, so the first U.S. high-yield index fund was actually an ETF. It was launched in 2007. I think it might have been late 2006. It's in the paper, I think April 2007. And it was relatively small at the time, and a small portfolio makes it a little bit more difficult. You're going to do more sampling. And so you had a U.S. high-yield index fund launched just before probably the most extreme credit crisis we have in our data set.

And you see it there. That was a very, very tricky time for all investors. It was also a tricky time if you were trying to replicate a broad-based bond index with a relatively narrow portfolio of high-yield bonds. So it's not a perfect record. But through those kinds of approaches and more, the record of index fund managers in terms of the longest-term histories that we have available for each segment is certainly credible and, for the past decade, is also pretty much it's -- apart from fees, it's a pretty perfect match.

Nathan Hunt: One of the parts of your article I found really interesting was when you talked about capitalized weighting, which is obviously a way of sort of determining how much of, let's say, in this particular case, a given bond you were going to put in your index and what the allocation should be there.

The issue that you draw is that there's a common sense objection to capitalized weighting, which is that it would just select for more indebted companies. And intuitively, that seems like a bad idea. Why would you invest in the most indebted companies? Is this a problem buying the debt of companies with the most debt?

Tim Edwards: So first of all, let me -- let's just acknowledge, what a good common sense objection. So by their nature, not all of the -- the typical creation of a broad market benchmark is it's capitalization weighted. And essentially, so it's a tiny copy of the market. The overall market, if you add up all the money invested in everything, you end up with a capitalization weighted part, right, if everything is capitalization weighted.

So the idea for a benchmark is, well, you'll create a tiny copy that, you'll have the same weight to the same securities. But the objection that in bonds, that means you are allocating more of your capital to entities that have issued more debt, I think, is a very, very important common sense objection. So okay, let's take it on. And there are a couple of things that, I think, importantly qualify that and then something very special that comes in.

Well, we put it at the end. You could put it first but I'll put it at the end. First common sense objection is, look, yes, that's true. But to the first and second degree of approximation, entities that issue large amounts of debt are large entities. They're not poor credit entities, they're just large entities, right? So the largest issuer in the world is the U.S. government. And then the next -- I don't know whether it's the next 10 or so, but the next few in terms of the largest issuers, they're all sovereign states of very high credit rating.

If you look across corporations and you sort of look at who are the largest issuers of debt, they're the largest companies. And we put some statistics in the paper that kind of show you genuinely to the first and to the second approximation size of debt is essentially a proxy for size of the company. But you may still object you say, "Okay, yes, okay. But within that, if I'm looking at companies of a similar size, why am I giving more money to those with more debt?" And there it gets a little subtle and the subtleties are, first of all, don't forget that there is a price component. If there is a company whose debt is perceived to be uncreditworthy, the price of those bonds will be lower, all else being equal, right?

And if they're about to default, the price of the bonds will be very low. So there is a natural mechanism that deallocates according to the market's perception of creditworthiness. The second thing to observe is there are guardrails. Most index funds, most benchmarks, most active funds as well have credit quality guardrails. They're allowed to invest in investment grade, say, or a certain range of credit ratings.

But it's not quite, to me, sufficient. That's not quite enough to okay, well then, why don't you do something else? Why do you do something more complicated? And in order to understand why they don't, you have to come back to the question of, well, what do you give up when you lose or when you move away from market cap weighting? And there, you lose 2 very special things. The first is that any investment of any size has an impact on the market. And you have to think about, how can I scale my investment?

And market cap weighting is the only way that sort of by definition, you are scaling your investment in proportion to the market's capability to accept your investment. And if you're buying 1% of this issue because you order a certain size, you're buying just 1% of the outstanding of all the other issues, you scale precisely with the size of the opportunity set. And that's very valuable, especially in the fixed income markets where liquidity can be a concern.

The second thing is down to a very special bit of arithmetic and you don't need calculus or a PhD for this one. But it is subtle and it is special and it's the following. Go back to, with me if you will, to where I started, market capitalization is a tiny copy of the whole market, right? So a market cap-weighted index or portfolio, that will do the same as the overall market. Now suppose there are also some active investors out there, right? And there always are and there always will be.

Well, some of them will be above the market. Some of them will be above that average. But for everyone that is above average, for everyone that makes a single cent more than sort of what the market does, someone else has to make exactly $0.01 less. There is no net supply of alpha, if you like. So that's still a little bit of arithmetic that you say you can either -- you can get the market or you can try and beat the market, but be aware that anyone who's trying to beat the market, there has to be someone else who is underneath the market, that is another very special characteristic of market capitalization weighting and something that you'd give up when you move to any other form of benchmark.

So for those 2 reasons, I think that's the trade-off. You say, okay, well, I'm not going to do additional credit quality or active management, if you like, beyond that, which I'm already taking from things like credit ratings and the market's pricing of the debt and then in return, you get scalability of investing and you get the knowledge that you are getting that average performance.

Nathan Hunt: Amazing. Love that answer. Tim, let's -- again, I'm going to ask a slightly simplistic question, I hope you'll forgive me. But when a mutual fund manager is investing based on a given index, let's say the S&P 500, is that index is regularly re-weighted? Necessarily, that mutual fund manager is going to be buying and selling some stocks. And there is going to be costs associated with the buying and selling. Within equities, that's sort of manageable, right? The costs are somewhat anticipatable and they're sort of built in, right, to management fees.

But within bond markets, you have maturities happening all the time, any kind of re-weighting is going to involve buying and selling of much more different assets. Isn't this another sort of common sense objection to indexing bond markets? That transactions involved in replicating the market will inevitably cause any kind of like mutual fund or ETF to be less profitable?

Tim Edwards: So the question is pertinent. The S&P 500, for example, over the past 10-or-so years precisely actually because I looked at the number. Over a 10-year period, you needed to -- on an annual basis, on one-way trading, you needed about 5% per annum of trading to keep up with the index. And that's including, by the way, that's including the reinvestment of all dividends. So about 2% of that is putting dividends that you get paid back in the market, and the rest of that 5% is adds and drops from the index.

But yes, once companies are in the index, they generally tend to stay. The things that get added and deleted tend to be the smallest piece. It's not always but they tend to be the smaller ones, and that's why you don't have an awful lot of trading. By comparison, you would not be surprised to see a level of trading that was even 10x as much in a standard fixed income benchmark, right, in terms of -- and you can see easily where that comes from.

You might have 5% coupons alone that you need to reinvest. If you have an average maturity of 5 years, well, by definition, that means 1/5 of your portfolio is maturing every year. So there's probably 20% that you need to deal with in terms of reinvesting bonds to mature, and there's probably 20% that you need to invest in terms of new bonds that become available. And all of a sudden, you very quickly come to a figure that's roughly 10x.

I think the important question is do you have to do more maintenance because the answer is very clearly, yes, you do. The question is, or the questions are, one, is this a fundamental difference between the way that actively managed funds are typically operated and maintained or do both active and passive fund managers face similar problems, if not identical? And secondly, what's the track record, right? I mean, that's the nice thing about having 10, 15, more, in some cases, a track record for index funds and say, "Okay, well, here's the index. Here's the fund. How did they do? Were they able to track the index over time?"

And the answers to those questions, I guess we've sort of already covered them. But first of all, this is -- that is a challenge, which is faced by both active and passive bond managers, right? Their bond portfolios require more maintenance. It's harder to build a long-term buy-and-hold bond portfolio than a buy-and-hold equity portfolio. That's not unique to index funds.

And then secondly and we have already mentioned this, the track record of the index funds that we looked at and for good reason, we looked at the ones with the longest track records, again, not perfect. We talked about 2007, running a small high-yield or relatively smaller high-yield U.S. credit funds, but not that at all. And all that you really need is that it'd be possible, if they can show that they can replicate the index, and they meaning fund providers offering index-based index funds or passive funds, they've managed to do so over, at least speaking in 2024, a 15-year period that covers, of course, the euro crisis, covers COVID pandemic, covers several changes in the regime in terms of interest rates and inflation and so on.

So there's no guarantee that they'll continue to do so in the future. And the question -- so coming back to the question is very pertinent. And I think part of the assessment for thinking if someone wanted to invest passively themselves and track an index or pick a manager to do that for them, whether or not they're able to track that index is a very important question because there's no question it requires a lot more work in the fixed income markets.

Nathan Hunt: Another point that you brought up, you and your co-authors brought up in the article that stopped me cold, even though I suppose it's pretty obvious, is that in fixed income markets, there are these nonprofit-maximizing actors, basically big players in the market who are not in there to make money. And that really surprised me, but of course, the big one there, the Federal Reserve Bank of the United States has been buying bonds as a tool of monetary policy rather than to try to make money. So how do you account for these market players? When you're indexing, how do you account for these market players that don't care necessarily about profit?

Tim Edwards: Yes. And it is -- I mean, in terms of the sort of my own personal development and understanding and assessment of, could index and could passive become as popular in fixed income as it has done in equities? This was one of the ones that I probably spent the longest thinking about because there's something very deep there, which is you have in the fixed income markets. Central banks are probably the poster people of this, and they are buying and selling in securities in those markets and their objective in doing so is not price sensitive.

They're trying to move the exchange rate. They're trying to change inflation. They're trying to support small businesses during the pandemic. And they're going to buy whatever happens to that price, right? So as a market participant who is seeking to profit, why don't I take advantage of that? Why don't I have a truly active strategy that looks to see which way the elephant herd is chasing towards and make sure that I'm there and ready in advance?

And there are very famous occasions where this has happened in history. And in fact, the Rothschilds. There are banking dynasties going back centuries that have been founded on the principle of having what governance need when they need to buy it. So the question becomes not so much is there an opportunity there but am I fast enough and smart enough to get it before anyone else does? And that's where the rubber hits the road. There's no question that one can take advantage. But in order to take advantage, you need to essentially predict what the Federal Reserve is going to do, not before they do it but before everyone else does it.

And unfortunately, that means you're back into that same competitive environment, the prices of bonds, the prices of interest rate futures brake, the prices of the U.S. dollar take into account not just what the Fed has done but what everyone else thinks they're going to do next. And you sort of come back to this, yes, there's opportunity there. But unfortunately, there is a ruthlessly competitive market to be the first to work it out.

Then when we dug a little bit deeper, there's actually grounds to suppose that the bond markets might be more difficult than the equity markets, and that comes from the following. Although you have central banks, another we call them nonprofit-maximizing participants in the bond markets. What you don't really have in the bond markets is direct retail investors. And in the equity markets, there is a decent chunk, I think in the U.S., I think it's around 25% or so of the U.S. equity market is held by households.

Stereotypically, this is someone who gets their paycheck and takes a little bit of their paycheck and buys a stock they like, or maybe nowadays, it's people trading GameStop and meme stocks on the basis of Internet forums. And there is a presumption that if you are a professional money manager and you have a, either from a fundamental perspective, you can better assess the value of a company or you just -- you're faster and less exuberantly distracted than these retail investors, perhaps you can take advantage.

So given that, one might suppose that equities would be easier. I mean, in fact, they both seem hard. I guess the takeaway point is, one, yes, there are elephants wandering around the fixed income jungle because it's very hard to take advantage for most people. And two, that market itself is a highly professional market, and you still come take the central banks out of the equation among the rest for anyone to be above average, that requires someone else to be below average. So the important question is how smart is the average. And the challenge is that average appears to be very smart indeed.

Nathan Hunt: Tim, I recently had Mary Childs on the podcast and she has written a book about famous or perhaps infamous bond investor, Bill Gross at PIMCO. So let's say for a moment that I am Bill Gross. And I am going to say to you that bonds need to be managed actively because the profit on a bond is set at the outset but the potential loss on a bond is 100%. Therefore, the upside and the downside in fixed income are totally different from equity markets. Even if passive investing works in equities, it can't work in fixed income. Now keep in mind, I'm Bill Gross saying that to you. So how would you answer Bill Gross?

Tim Edwards: Yes. And look, Bill, first of all, we were talking about people who famously went against governments. And I have to say, when you were all the way through the early 2010s, I read what you wrote and I thoroughly agreed with it, and it should demonstrate how difficult it is to trade ahead and take the other side from a government.

But to come to your question, and this is a really interesting facet that goes into -- and you have to go -- you have to move away from sovereign bonds and into credit for this to have a real resonance, right? But if you're in a credit universe, some proportion could be more, could be less. But some proportion of bonds in the universe are going to default in any given year. Typically, a small proportion, 4%, something like that, I think is the S&P official ratings average for U.S. high yield over the last 25 years or something like 4% on average.

And this sounds like an argument, sort of intellectual argument for bond picking because actually, if you pick 1 bond, you have to be really unlucky to get a defaulting one. It's an argument for trade. Just pick one, be very, very carefully pick one because -- sorry, 96% of them won't default but 4% of them will. And so you have to be really unlucky to have one of those few defaults.

And first of all, let's just acknowledge that, that is true. And if you can outperform, I guess, we haven't sort of done the additional step of pointing out that what a bond benchmark would do, it would have all of them. So without all the ones that got that locked in profit, it would have a small proportion of default that would weigh down the average. So concentration and individual bond picking seemingly, temptingly looks like a way to almost guarantee outperformance.

Unfortunately, perhaps, 2 things remain true. The first is that diversification is still famously the only free lunch available in finance. If you are unlucky in this scenario, you basically lose all your money. If you're lucky, you'll get decent -- yes, perhaps a high-yield kind of return, maybe 8%, 6% or something like that. But if you're unlucky, then you're out of the game and you don't get to play again next year.

And in fact, diversification is not unique to indexing. The world's first-ever mutual fund, an actively managed mutual fund was launched in Holland about 3 centuries ago, and its stated goal was to offer diversification because, yes, if you invest all your money in one bond and it goes under, that's it, game over for you. Whereas if you have a broad portfolio, you can take 1 or maybe 2 losses, and you get to stay in the game for the following year.

And the analysis that we did in the paper was to extend this, which is kind of obvious. I think most people intuitively know this and understand this. To extend this and point out, when you add in this notion of staying in the game, right, because the context that we're talking in here, even high-yield bonds, it's a small fraction, 4%, 1 in 25. It's not a lot. But many investors actually have a 25 or longer time horizon for their investment.

And when you repeat that process continuously again and again and again, even the -- you don't even need to bring in the risk component to it, but the single thing, I want higher return because if you go over the long term, it's almost inevitable that you have something bad will happen or at least becomes likely that something bad will happen. There, that process of using diversification to limit your losses so that over compounded returns, you still stay in the game and benefit from what ultimately on the long term has been a positive return.

Over the long term, high-yield bonds, including in their defaults, in the aggregates, have had a decent return. But it's that staying in the game component when you invest not just for 1 year but for this year and the next year and the year after and the year after, that means that the sort of argument for concentrated bond selection does, yes, work in the short term with an awful lot of risk but doesn't even work on a return basis in the long term.

Nathan Hunt: Okay. So Tim, let's stay with the idea that I am Bill Gross right now.

Tim Edwards: You're enjoying that, aren't you?

Nathan Hunt: I'm enjoying it. He's on CNBC a lot. It's working for me. So I'm still Bill Gross and I say to you, "Tim, the right active investor will always beat passive investors. You just need to find the right active investor," and I'm sure Bill would suggest it was him. What do you say? I mean, are there these people who just are -- they're alpha machines?

Tim Edwards: Well, Bill, I think we would be in harmony actually. So we shared in the paper and continue to update a so-called scorecard, an active versus passive scorecard that looks around equity fixed income markets around the world and report statistics in any given year or 10 years or 5 years in this or that market segment, how many actively managed funds beat or didn't beat the category benchmark.

And on the one hand, the statistics suggests that it is hard to find outperforming managers. In the U.S., for example, just to rattle through them, 15 years, government investment grade and high-yield categories saw 81% underperformed, government, 94% underperformed investment grade, 80% funds underperforming the high-yield bond index over 15 years. So they're hard to find.

I mean, that's evidencing the point that you're indexing or following an average, although it sounds average is not necessarily average. It may actually be better than a lot of the alternatives. But in every category, the happy managers who do outperform. We've talked about it. There are clearly opportunities. If you can avoid those bonds that default, if you can stay one step ahead of these elephants and central banks and nonprofit-maximizing participants, then there are rewards to be found.

The challenge and the real challenge is identifying those funds in advance is very, very difficult. And Bill Gross was -- he was so, I guess, widely respected back in the early sort of 2010s and so on, but the U.S. Federal Reserve themselves asked, and this is covered entertainingly in Mary's book actually, asked him, asked PIMCO to help them manage their investments when they wanted to direct capital through into the underlying economy.

It is interesting, I think, and possibly a signal that when in 2020 and 2021, when they launched the credit facilities aimed at supplying capital to small- and medium-sized companies in the U.S., the vehicle that they chose to do that, the manager that they chose to do that wasn't, this time, an active manager. They put a lot in, in the end. So often the signal is more important than the actual act. But I thought it was very interesting that this time around or that time around, the U.S. Federal Reserve chose to direct their capital into exchange-traded funds into index funds.

I guess there's, I guess, a final thought if you like. The world has changed. It's still the case that there are skilled, talented, and lucky managers who will outperform in the future but they are very, very difficult to find. And the opportunity to use index-based tools to manage country, duration, credit, liquidity needs is such that it does seem like there's a toolkit there that people could potentially take more advantage of. Even if they are active, get fundamentally active, there are tools available to you that can help complement, augment, or control risks in the portfolio, thanks to index funds.

Nathan Hunt: Well, Tim, for myself and for the fictional Bill Gross who joined us today, I'd like to thank you for joining me on the podcast.

Tim Edwards: Thank you both for having me.

Nathan Hunt: The Essential Podcast is produced by Patrick Moroney. At S&P Global, we accelerate progress in the world, providing intelligence that is essential for companies, governments, and individuals to make decisions with conviction. From the majestic heights of 55 Water Street in Manhattan, I'm Nathan Hunt. Thank you for listening.


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Transcript Provided by Kensho

Nathan Hunt: This is The Essential Podcast from S&P Global. My name is Nathan Hunt. Indexing is big business. This makes a lot of active investors nervous. This makes a kind of sense. If more people chose to invest passively, it might make it hard to collect your fees. Well, passive investing has become more popular in equity markets over the years. The place active investors felt safe and protected was fixed income markets. After all, bond markets are far too large and complex to ever be indexed effectively. Or so we have been led to believe.

I'm joined today by Tim Edwards, Managing Director of the Index Investment Strategy Group at S&P Dow Jones Indices. I suspect Tim has some bad news for active investors about fixed income markets and indexing. Let's hope the news isn't all bad. Tim, welcome to the podcast.

Tim Edwards: Thanks for having me, Nathan.

Nathan Hunt: Tim, I'm afraid we need to start with a rather basic question just to level set for our listeners. A lot of people think that creating an index is a simple process of just grab the top 30 or perhaps the top 500 biggest companies in the world and say, here's my group. Judging by the fact that you have a PhD in mathematics from University College London, I'm going to guess that there's a little bit more that goes into this. Can you talk a little bit about that?

Tim Edwards: Yes, certainly. So first of all, it is actually not that complicated to create any index or certainly to create some indices. In fact, the first recognized index of the markets was an equity index, and it was launched over 125 years ago by a gentleman called Charles Dow who would go on to found the Wall Street Journal and whose surname is still there in the name of the company, S&P Dow Jones Indices.

And it's still famous today as an index, the Dow. The Dow, its full name the Dow Jones Industrial Average, and actually, that you can calculate, you don't even need a slide rule. You just -- it's 30 stocks and you add up all their prices and you see how that evolves from day to day. And the reason that Charles Dow started doing that was because he wanted a simple way to describe not how one or another part of the market was doing but how the overall market was doing. And he wanted to condense it down into a single number.

Now indices have evolved considerably through the -- nearly say centuries, but in the 130-odd years since, other important milestones to notice. 1957 was when indexing went digital. Another of the brands in our stable, if you like, that was when the S&P 500 was created in its current form. And what was exciting about that wasn't the fact that it was 500 rather than 30 stocks. They did have more complicated calculators by then, but it was that it published every 15 seconds so you could watch the market intraday.

Now that's still a good -- well, many decades ago. Since then, the notion of indexing has extended to beyond just fixed numbers of stocks or fixed numbers of U.S. stocks but to a very diverse range of different indices, some of which are a bit more sophisticated. I mean, I'll give you the example of something like VIX, which is essentially a measure of how expensive options are. That's a very sophisticated index, and you probably do need, if not a PhD in mathematics, then at least a bit of calculus to understand how that's built.

We're going to talk today about our fixed income indices. They do have a more recent history. They're not as old. They tend to be a lot broader. The fixed income markets are a lot more granular. And they do take quite a bit more careful care in building, maintaining an ongoing calculation.

Nathan Hunt: So as you say, a lot of my questions today are going to be about an article that you co-wrote that can be found on the S&P Dow Jones Indices website, and it's called The Hare and the Tortoise - Assessing Passive’s Potential in Bonds. Using your analogy from the fable, who is the hare here and who is the tortoise?

Tim Edwards: Yes, we did call it The Hare and the Tortoise and there's not a single one-to-one correspondence. I think that was one of the reasons I chose that title. There's actually, if you like, 2 hares and 2 tortoises. In one sense, the equity markets are the hare. They're exciting, they're glamorous. People make and lose fortunes every day. The markets are -- the equity markets are far more excitingly and enthusiastically followed by the media.

And the tortoise is the sort of bloody old, careful, watch my yield, careful with my credit fixed income markets. But there's another sense that I was playing on in which the stock pickers, the bond pickers, the masters of Wall Street, they're the hares. They are the ones who are racing ahead with their fast feet and maybe with a little bit more showy, maybe a little bit more complacent.

And the bloody old index funds represent the tortoise. Eyes fixed on a long-term goal, thinking about things like diversification and cost management, very tortoise-y approaches. But one which as in the story, the evidence suggests may, in the long term, deliver surprising results.

Nathan Hunt: Excellent. Passive investing is well established in equity markets. What is it about fixed income markets that makes passive investing more challenging?

Tim Edwards: There's actually -- there's a few different reasons. I guess I'll try and summarize them. And then if you like, we can dig down a little deeper in any one of these different dimensions. The first and probably the most important, we've already touched on it, is that indexing or passive approaches to the bond markets are much more difficult to implement.

So we talked about the S&P 500. That's 500 companies. It's actually 503 shares because some of the companies have got dual listings. So you've got 2 shares you've got to buy to get the whole company. But just 500 securities covers between, over time, historically, between 2/3, 3/4 of the total U.S. equity market. The average price to buy one of those shares is around $200. You can pretty much replicate that portfolio perfectly or very close to perfectly without a vast amount of capital.

Just to give you one comparison, right? So those same 500 companies that make up the S&P 500, if you wanted to capture all the debt or fixed income securities that was issued by those companies, you would need a portfolio comprising over 6,000 distinct securities. And not only that, they have an average maturity of between -- I mean, it varies over time, but around 5, 5-and-a-bit years. So 20% of your portfolio is maturing every year. Things are getting upgraded or downgraded through investment grade. There's new bonds issuing all the time.

And they don't all cost just $200. Some bonds are lumpy. And so immediately, you can see that in order to even think about replicating a broad market fixed income index, you're going to need, well, first of all, probably a bit more capital. Second of all, you're going to need some degree of sampling or some sophisticated strategies to say, okay, how can I replicate the performance without only one of everything? So that's one piece, just the practical difficulty.

That's probably the most important reason why it came later. There are other reasons which are really more to do with, I guess the investment case rather than, can I do it? And then if I can do it, why would I do it or not? And I think there are several -- we used the word theological in the paper because I think some of these are -- it's almost a theological opinion that suggests that, well, the equity markets, they're very efficient. They're very fast. I see why indexing will work there, but the bond markets are different.

The value of credit selection, the value of actively managing in the bond markets is much, much higher. And I think -- I expect we'll go into 1 or 2 of those aspects, but this, I think, is where the allegory between the hare and the tortoise really comes through because it looks like that might be the case, and there are some good common sense arguments why you might think that indexing or passive investing is a foolish approach in the bond markets, but the long-term evidence suggests that actually, it's not only outcomes achieved by index funds have been such as to put them among the very highest of performers in relative terms.

Nathan Hunt: Okay. Well, let's dive into one of those. You talk about the challenge of replication, right? This is something that is, of course, increasingly complex in equity markets. But when it comes to bond markets, as you say, we're talking about 6,000 different assets. They are lumpy. How do you even begin to replicate bond markets with an index? Like what is the mechanism that is used to accomplish that?

Tim Edwards: Well, look, and this is something where we, as an index provider, can acknowledge the expertise of the asset managers who then have the task of replicating that index. There are some things that an index provider could do. For example, narrowing the universe perhaps to only more liquid, only investment-grade, only U.S. dollar-denominated securities. And then so you can sort of define the universe a little bit more carefully and in a representative way, of course.

But there are S&P 500 companies that are high yield or that are issuing bonds in nondollar currencies. So there's one sense which the index can evolve to meet the needs of an investment rather than just a total market capture. Then from a replication perspective and then again, this is the expertise of the index fund manager or the portfolio manager, there are certain well-established approaches.

The first is, to a large degree, a bond portfolio will be -- the performance of a bond portfolio will be determined by the credit quality or the average credit quality, the duration profile, the sectoral profile, the degree of diversification and other things that we've already established like currency. So you can see how at least the problem is addressable in practice and what we included in the paper was a sort of ex post "Okay, well, how did they do?"

We picked -- sort of for good reason, we picked a few first movers in this space, right? So the first ever bond index fund was introduced in 1986. It took another -- was it 14 -- 16 years, sorry, for the next tranche when you got investment-grade and high-yield bonds, bond indices launched in ETF for U.S. dollars. And then a few years later, with the final one coming in 2010, you also had euro investment grade and high-yield bond universes replicated by index funds or ETFs in some cases.

So you have these, okay, well, over their whole life, we've got a decent 10-plus years or 15 or even back to 1986. How did these index tracking or putatively index tracking funds do as compared to their index? And there, the data is pretty compelling that over decades, through, for example, sort of sampling approaches, through also being able to attract more assets to cover more of the index, these funds were largely able to replicate the indices that they were designed to track.

However, and we do highlight, so the first U.S. high-yield index fund was actually an ETF. It was launched in 2007. I think it might have been late 2006. It's in the paper, I think April 2007. And it was relatively small at the time, and a small portfolio makes it a little bit more difficult. You're going to do more sampling. And so you had a U.S. high-yield index fund launched just before probably the most extreme credit crisis we have in our data set.

And you see it there. That was a very, very tricky time for all investors. It was also a tricky time if you were trying to replicate a broad-based bond index with a relatively narrow portfolio of high-yield bonds. So it's not a perfect record. But through those kinds of approaches and more, the record of index fund managers in terms of the longest-term histories that we have available for each segment is certainly credible and, for the past decade, is also pretty much it's -- apart from fees, it's a pretty perfect match.

Nathan Hunt: One of the parts of your article I found really interesting was when you talked about capitalized weighting, which is obviously a way of sort of determining how much of, let's say, in this particular case, a given bond you were going to put in your index and what the allocation should be there.

The issue that you draw is that there's a common sense objection to capitalized weighting, which is that it would just select for more indebted companies. And intuitively, that seems like a bad idea. Why would you invest in the most indebted companies? Is this a problem buying the debt of companies with the most debt?

Tim Edwards: So first of all, let me -- let's just acknowledge, what a good common sense objection. So by their nature, not all of the -- the typical creation of a broad market benchmark is it's capitalization weighted. And essentially, so it's a tiny copy of the market. The overall market, if you add up all the money invested in everything, you end up with a capitalization weighted part, right, if everything is capitalization weighted.

So the idea for a benchmark is, well, you'll create a tiny copy that, you'll have the same weight to the same securities. But the objection that in bonds, that means you are allocating more of your capital to entities that have issued more debt, I think, is a very, very important common sense objection. So okay, let's take it on. And there are a couple of things that, I think, importantly qualify that and then something very special that comes in.

Well, we put it at the end. You could put it first but I'll put it at the end. First common sense objection is, look, yes, that's true. But to the first and second degree of approximation, entities that issue large amounts of debt are large entities. They're not poor credit entities, they're just large entities, right? So the largest issuer in the world is the U.S. government. And then the next -- I don't know whether it's the next 10 or so, but the next few in terms of the largest issuers, they're all sovereign states of very high credit rating.

If you look across corporations and you sort of look at who are the largest issuers of debt, they're the largest companies. And we put some statistics in the paper that kind of show you genuinely to the first and to the second approximation size of debt is essentially a proxy for size of the company. But you may still object you say, "Okay, yes, okay. But within that, if I'm looking at companies of a similar size, why am I giving more money to those with more debt?" And there it gets a little subtle and the subtleties are, first of all, don't forget that there is a price component. If there is a company whose debt is perceived to be uncreditworthy, the price of those bonds will be lower, all else being equal, right?

And if they're about to default, the price of the bonds will be very low. So there is a natural mechanism that deallocates according to the market's perception of creditworthiness. The second thing to observe is there are guardrails. Most index funds, most benchmarks, most active funds as well have credit quality guardrails. They're allowed to invest in investment grade, say, or a certain range of credit ratings.

But it's not quite, to me, sufficient. That's not quite enough to okay, well then, why don't you do something else? Why do you do something more complicated? And in order to understand why they don't, you have to come back to the question of, well, what do you give up when you lose or when you move away from market cap weighting? And there, you lose 2 very special things. The first is that any investment of any size has an impact on the market. And you have to think about, how can I scale my investment?

And market cap weighting is the only way that sort of by definition, you are scaling your investment in proportion to the market's capability to accept your investment. And if you're buying 1% of this issue because you order a certain size, you're buying just 1% of the outstanding of all the other issues, you scale precisely with the size of the opportunity set. And that's very valuable, especially in the fixed income markets where liquidity can be a concern.

The second thing is down to a very special bit of arithmetic and you don't need calculus or a PhD for this one. But it is subtle and it is special and it's the following. Go back to, with me if you will, to where I started, market capitalization is a tiny copy of the whole market, right? So a market cap-weighted index or portfolio, that will do the same as the overall market. Now suppose there are also some active investors out there, right? And there always are and there always will be.

Well, some of them will be above the market. Some of them will be above that average. But for everyone that is above average, for everyone that makes a single cent more than sort of what the market does, someone else has to make exactly $0.01 less. There is no net supply of alpha, if you like. So that's still a little bit of arithmetic that you say you can either -- you can get the market or you can try and beat the market, but be aware that anyone who's trying to beat the market, there has to be someone else who is underneath the market, that is another very special characteristic of market capitalization weighting and something that you'd give up when you move to any other form of benchmark.

So for those 2 reasons, I think that's the trade-off. You say, okay, well, I'm not going to do additional credit quality or active management, if you like, beyond that, which I'm already taking from things like credit ratings and the market's pricing of the debt and then in return, you get scalability of investing and you get the knowledge that you are getting that average performance.

Nathan Hunt: Amazing. Love that answer. Tim, let's -- again, I'm going to ask a slightly simplistic question, I hope you'll forgive me. But when a mutual fund manager is investing based on a given index, let's say the S&P 500, is that index is regularly re-weighted? Necessarily, that mutual fund manager is going to be buying and selling some stocks. And there is going to be costs associated with the buying and selling. Within equities, that's sort of manageable, right? The costs are somewhat anticipatable and they're sort of built in, right, to management fees.

But within bond markets, you have maturities happening all the time, any kind of re-weighting is going to involve buying and selling of much more different assets. Isn't this another sort of common sense objection to indexing bond markets? That transactions involved in replicating the market will inevitably cause any kind of like mutual fund or ETF to be less profitable?

Tim Edwards: So the question is pertinent. The S&P 500, for example, over the past 10-or-so years precisely actually because I looked at the number. Over a 10-year period, you needed to -- on an annual basis, on one-way trading, you needed about 5% per annum of trading to keep up with the index. And that's including, by the way, that's including the reinvestment of all dividends. So about 2% of that is putting dividends that you get paid back in the market, and the rest of that 5% is adds and drops from the index.

But yes, once companies are in the index, they generally tend to stay. The things that get added and deleted tend to be the smallest piece. It's not always but they tend to be the smaller ones, and that's why you don't have an awful lot of trading. By comparison, you would not be surprised to see a level of trading that was even 10x as much in a standard fixed income benchmark, right, in terms of -- and you can see easily where that comes from.

You might have 5% coupons alone that you need to reinvest. If you have an average maturity of 5 years, well, by definition, that means 1/5 of your portfolio is maturing every year. So there's probably 20% that you need to deal with in terms of reinvesting bonds to mature, and there's probably 20% that you need to invest in terms of new bonds that become available. And all of a sudden, you very quickly come to a figure that's roughly 10x.

I think the important question is do you have to do more maintenance because the answer is very clearly, yes, you do. The question is, or the questions are, one, is this a fundamental difference between the way that actively managed funds are typically operated and maintained or do both active and passive fund managers face similar problems, if not identical? And secondly, what's the track record, right? I mean, that's the nice thing about having 10, 15, more, in some cases, a track record for index funds and say, "Okay, well, here's the index. Here's the fund. How did they do? Were they able to track the index over time?"

And the answers to those questions, I guess we've sort of already covered them. But first of all, this is -- that is a challenge, which is faced by both active and passive bond managers, right? Their bond portfolios require more maintenance. It's harder to build a long-term buy-and-hold bond portfolio than a buy-and-hold equity portfolio. That's not unique to index funds.

And then secondly and we have already mentioned this, the track record of the index funds that we looked at and for good reason, we looked at the ones with the longest track records, again, not perfect. We talked about 2007, running a small high-yield or relatively smaller high-yield U.S. credit funds, but not that at all. And all that you really need is that it'd be possible, if they can show that they can replicate the index, and they meaning fund providers offering index-based index funds or passive funds, they've managed to do so over, at least speaking in 2024, a 15-year period that covers, of course, the euro crisis, covers COVID pandemic, covers several changes in the regime in terms of interest rates and inflation and so on.

So there's no guarantee that they'll continue to do so in the future. And the question -- so coming back to the question is very pertinent. And I think part of the assessment for thinking if someone wanted to invest passively themselves and track an index or pick a manager to do that for them, whether or not they're able to track that index is a very important question because there's no question it requires a lot more work in the fixed income markets.

Nathan Hunt: Another point that you brought up, you and your co-authors brought up in the article that stopped me cold, even though I suppose it's pretty obvious, is that in fixed income markets, there are these nonprofit-maximizing actors, basically big players in the market who are not in there to make money. And that really surprised me, but of course, the big one there, the Federal Reserve Bank of the United States has been buying bonds as a tool of monetary policy rather than to try to make money. So how do you account for these market players? When you're indexing, how do you account for these market players that don't care necessarily about profit?

Tim Edwards: Yes. And it is -- I mean, in terms of the sort of my own personal development and understanding and assessment of, could index and could passive become as popular in fixed income as it has done in equities? This was one of the ones that I probably spent the longest thinking about because there's something very deep there, which is you have in the fixed income markets. Central banks are probably the poster people of this, and they are buying and selling in securities in those markets and their objective in doing so is not price sensitive.

They're trying to move the exchange rate. They're trying to change inflation. They're trying to support small businesses during the pandemic. And they're going to buy whatever happens to that price, right? So as a market participant who is seeking to profit, why don't I take advantage of that? Why don't I have a truly active strategy that looks to see which way the elephant herd is chasing towards and make sure that I'm there and ready in advance?

And there are very famous occasions where this has happened in history. And in fact, the Rothschilds. There are banking dynasties going back centuries that have been founded on the principle of having what governance need when they need to buy it. So the question becomes not so much is there an opportunity there but am I fast enough and smart enough to get it before anyone else does? And that's where the rubber hits the road. There's no question that one can take advantage. But in order to take advantage, you need to essentially predict what the Federal Reserve is going to do, not before they do it but before everyone else does it.

And unfortunately, that means you're back into that same competitive environment, the prices of bonds, the prices of interest rate futures brake, the prices of the U.S. dollar take into account not just what the Fed has done but what everyone else thinks they're going to do next. And you sort of come back to this, yes, there's opportunity there. But unfortunately, there is a ruthlessly competitive market to be the first to work it out.

Then when we dug a little bit deeper, there's actually grounds to suppose that the bond markets might be more difficult than the equity markets, and that comes from the following. Although you have central banks, another we call them nonprofit-maximizing participants in the bond markets. What you don't really have in the bond markets is direct retail investors. And in the equity markets, there is a decent chunk, I think in the U.S., I think it's around 25% or so of the U.S. equity market is held by households.

Stereotypically, this is someone who gets their paycheck and takes a little bit of their paycheck and buys a stock they like, or maybe nowadays, it's people trading GameStop and meme stocks on the basis of Internet forums. And there is a presumption that if you are a professional money manager and you have a, either from a fundamental perspective, you can better assess the value of a company or you just -- you're faster and less exuberantly distracted than these retail investors, perhaps you can take advantage.

So given that, one might suppose that equities would be easier. I mean, in fact, they both seem hard. I guess the takeaway point is, one, yes, there are elephants wandering around the fixed income jungle because it's very hard to take advantage for most people. And two, that market itself is a highly professional market, and you still come take the central banks out of the equation among the rest for anyone to be above average, that requires someone else to be below average. So the important question is how smart is the average. And the challenge is that average appears to be very smart indeed.

Nathan Hunt: Tim, I recently had Mary Childs on the podcast and she has written a book about famous or perhaps infamous bond investor, Bill Gross at PIMCO. So let's say for a moment that I am Bill Gross. And I am going to say to you that bonds need to be managed actively because the profit on a bond is set at the outset but the potential loss on a bond is 100%. Therefore, the upside and the downside in fixed income are totally different from equity markets. Even if passive investing works in equities, it can't work in fixed income. Now keep in mind, I'm Bill Gross saying that to you. So how would you answer Bill Gross?

Tim Edwards: Yes. And look, Bill, first of all, we were talking about people who famously went against governments. And I have to say, when you were all the way through the early 2010s, I read what you wrote and I thoroughly agreed with it, and it should demonstrate how difficult it is to trade ahead and take the other side from a government.

But to come to your question, and this is a really interesting facet that goes into -- and you have to go -- you have to move away from sovereign bonds and into credit for this to have a real resonance, right? But if you're in a credit universe, some proportion could be more, could be less. But some proportion of bonds in the universe are going to default in any given year. Typically, a small proportion, 4%, something like that, I think is the S&P official ratings average for U.S. high yield over the last 25 years or something like 4% on average.

And this sounds like an argument, sort of intellectual argument for bond picking because actually, if you pick 1 bond, you have to be really unlucky to get a defaulting one. It's an argument for trade. Just pick one, be very, very carefully pick one because -- sorry, 96% of them won't default but 4% of them will. And so you have to be really unlucky to have one of those few defaults.

And first of all, let's just acknowledge that, that is true. And if you can outperform, I guess, we haven't sort of done the additional step of pointing out that what a bond benchmark would do, it would have all of them. So without all the ones that got that locked in profit, it would have a small proportion of default that would weigh down the average. So concentration and individual bond picking seemingly, temptingly looks like a way to almost guarantee outperformance.

Unfortunately, perhaps, 2 things remain true. The first is that diversification is still famously the only free lunch available in finance. If you are unlucky in this scenario, you basically lose all your money. If you're lucky, you'll get decent -- yes, perhaps a high-yield kind of return, maybe 8%, 6% or something like that. But if you're unlucky, then you're out of the game and you don't get to play again next year.

And in fact, diversification is not unique to indexing. The world's first-ever mutual fund, an actively managed mutual fund was launched in Holland about 3 centuries ago, and its stated goal was to offer diversification because, yes, if you invest all your money in one bond and it goes under, that's it, game over for you. Whereas if you have a broad portfolio, you can take 1 or maybe 2 losses, and you get to stay in the game for the following year.

And the analysis that we did in the paper was to extend this, which is kind of obvious. I think most people intuitively know this and understand this. To extend this and point out, when you add in this notion of staying in the game, right, because the context that we're talking in here, even high-yield bonds, it's a small fraction, 4%, 1 in 25. It's not a lot. But many investors actually have a 25 or longer time horizon for their investment.

And when you repeat that process continuously again and again and again, even the -- you don't even need to bring in the risk component to it, but the single thing, I want higher return because if you go over the long term, it's almost inevitable that you have something bad will happen or at least becomes likely that something bad will happen. There, that process of using diversification to limit your losses so that over compounded returns, you still stay in the game and benefit from what ultimately on the long term has been a positive return.

Over the long term, high-yield bonds, including in their defaults, in the aggregates, have had a decent return. But it's that staying in the game component when you invest not just for 1 year but for this year and the next year and the year after and the year after, that means that the sort of argument for concentrated bond selection does, yes, work in the short term with an awful lot of risk but doesn't even work on a return basis in the long term.

Nathan Hunt: Okay. So Tim, let's stay with the idea that I am Bill Gross right now.

Tim Edwards: You're enjoying that, aren't you?

Nathan Hunt: I'm enjoying it. He's on CNBC a lot. It's working for me. So I'm still Bill Gross and I say to you, "Tim, the right active investor will always beat passive investors. You just need to find the right active investor," and I'm sure Bill would suggest it was him. What do you say? I mean, are there these people who just are -- they're alpha machines?

Tim Edwards: Well, Bill, I think we would be in harmony actually. So we shared in the paper and continue to update a so-called scorecard, an active versus passive scorecard that looks around equity fixed income markets around the world and report statistics in any given year or 10 years or 5 years in this or that market segment, how many actively managed funds beat or didn't beat the category benchmark.

And on the one hand, the statistics suggests that it is hard to find outperforming managers. In the U.S., for example, just to rattle through them, 15 years, government investment grade and high-yield categories saw 81% underperformed, government, 94% underperformed investment grade, 80% funds underperforming the high-yield bond index over 15 years. So they're hard to find.

I mean, that's evidencing the point that you're indexing or following an average, although it sounds average is not necessarily average. It may actually be better than a lot of the alternatives. But in every category, the happy managers who do outperform. We've talked about it. There are clearly opportunities. If you can avoid those bonds that default, if you can stay one step ahead of these elephants and central banks and nonprofit-maximizing participants, then there are rewards to be found.

The challenge and the real challenge is identifying those funds in advance is very, very difficult. And Bill Gross was -- he was so, I guess, widely respected back in the early sort of 2010s and so on, but the U.S. Federal Reserve themselves asked, and this is covered entertainingly in Mary's book actually, asked him, asked PIMCO to help them manage their investments when they wanted to direct capital through into the underlying economy.

It is interesting, I think, and possibly a signal that when in 2020 and 2021, when they launched the credit facilities aimed at supplying capital to small- and medium-sized companies in the U.S., the vehicle that they chose to do that, the manager that they chose to do that wasn't, this time, an active manager. They put a lot in, in the end. So often the signal is more important than the actual act. But I thought it was very interesting that this time around or that time around, the U.S. Federal Reserve chose to direct their capital into exchange-traded funds into index funds.

I guess there's, I guess, a final thought if you like. The world has changed. It's still the case that there are skilled, talented, and lucky managers who will outperform in the future but they are very, very difficult to find. And the opportunity to use index-based tools to manage country, duration, credit, liquidity needs is such that it does seem like there's a toolkit there that people could potentially take more advantage of. Even if they are active, get fundamentally active, there are tools available to you that can help complement, augment, or control risks in the portfolio, thanks to index funds.

Nathan Hunt: Well, Tim, for myself and for the fictional Bill Gross who joined us today, I'd like to thank you for joining me on the podcast.

Tim Edwards: Thank you both for having me.

Nathan Hunt: The Essential Podcast is produced by Patrick Moroney. At S&P Global, we accelerate progress in the world, providing intelligence that is essential for companies, governments, and individuals to make decisions with conviction. From the majestic heights of 55 Water Street in Manhattan, I'm Nathan Hunt. Thank you for listening.

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