|October 26, 2011|
Page 4 of 8
The investment grade corporate bonds example points to strong technical reasons why a risk-based approach to building a benchmark should be preferred: asset-based breakdowns usually result in more extreme correlations than risk-based ones. Moreover, correlations among risk types are more stable than the ones among various assets. For example, US corporates and Treasuries (or rates) were highly correlated before the 2008 credit crisis (see the second column in Figure 6) and then had a small correlation during the crisis, only for their correlation to increase sharply again afterwards.
Alternatively, we can separate US corporates risk into rates (or Treasury) risk and spread risk. The last column in Figure 6 shows the correlation between the risk factors associated with rates and spread risk as consistently negative. While this correlation becomes larger over the three periods, it does not reach the extremes observed with asset class correlations.
A risk-based index should therefore be designed using risk-type building blocks5 as opposed to asset-based building blocks. This method results in more stable and reliable index construction.