Many trade finance funds fail because they do not use comparable benchmarks. Consequently, critical investors disregard a relatively low-volatility and low-risk asset class, missing a unique niche investment opportunity.
Our recent in-house research found that none of the trade finance funds we examined currently benchmark against a private debt index, which we consider a better fit than a public debt index that follows other criteria.
This article examines the benchmarks many trade finance funds use and their associated challenges. I will discuss alternatives and explain why private debt indices are appropriate. By offering a comparable risk-return profile, better-selected benchmarks allow improved analysis and judgment about a fund’s behavior, boosting investors’ understanding and confidence in the trade finance sector.
Common Benchmarks And Their Shortcomings
Most trade finance funds use straight benchmarks such as central bank interest rates or public debt indices. However, trade finance funds invest in financial instruments such as letters of credit, often combined with (export) credit insurance, which, in addition to producing a yield, smooth the exchange of goods and services and mitigate risks like non- or late payment, features that are not included in a straight interest-producing asset.
Trade investments often generate an equity-like yield from a trading margin, not interest, rendering interest rate-based benchmarks less comparable; yields from private debt investments are a more appropriate comparison. Any index that includes public debt—such as leveraged loans, high-yield bonds or money market funds—is also irrelevant because trade finance does not deal with such vehicles.
In today’s interest rate scenario, benchmarking a fund to interest rates or public debt means comparing a 14% to 20% per annum trade finance investment yield in the private debt sector with a 4% to 8% return in the public debt index. Investors might find such comparisons confusing or inappropriate and might need more confidence.
What Could A Bespoke Benchmark Look Like For Trade Finance?
Let’s explore more suitable benchmarking solutions, such as a bespoke benchmark. A bespoke benchmark is a custom index explicitly designed for a particular investment strategy or asset class, such as trade finance. It allows for a more accurate comparison of volatility and performance in your trade finance fund.
While this would provide an accurate view of risk and return, it will not give the investors a validated or familiar index they can trust and feel comfortable with. Customized benchmarks are often complex to compile as sourcing the data might be expensive and require subscriptions to multiple specialist providers.
Why Is A Familiar Index Important For Investor Confidence?
Benchmarking against a well-known equity index such as the S&P 500 could be another way to familiarize oneself with the index. However, the risk-return profile in equity indices does not relate well to any private debt investments; trade finance is a subset.
Many trade finance funds enjoy lower volatility than other asset classes, including equities and many parts of the public debt market. To illustrate, in market crashes such as the global financial crisis 2008, where the stock market experienced a severe downturn, trade finance funds were generally much less affected than equity funds and behaved better during volatile periods. Trade finance is not comparable with private equity benchmarks, either.
This combination of premium returns and low downside risk gives trade finance funds strong potential for investors. The challenge is to find a benchmark that provides confidence—a validated index that compares accurately.
Are Private Debt Benchmarks The Better Choice?
After careful analysis, private debt benchmarks emerge as the best fit for trade finance funds. These indices have loan and risk-return profiles that closely resemble those of trade finance funds. They are “private sector-related,” meaning they primarily consist of loans and investments made in the private sector without exposure to public debt.
For example, one private debt index returned around 12% in 2023 and 9% on average over the past five years, providing a more accurate comparison to trade finance investments. While some trade finance funds have outperformed private debt indices, others haven’t.
With private debt indexes providing more accuracy in benchmarking, why trade funds haven’t used private debt indices and instead used less appropriate benchmarks remains open for speculation.
Be this as it may, using less relevant comparisons undermines investor confidence regardless of the investment sector or asset class.
A more appropriate benchmark provides more transparency and confidence in the market and the asset class.
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Original article posted on Forbes Finance Council: https://www.forbes.com/councils/forbesfinancecouncil/2024/07/02/trade-finance-solving-benchmark-challenges-in-a-compelling-asset-class/