Challenge for active managers
Enhanced indexing is a quantitatively structured alternative to active management. Unlike indexing that seeks to replicate the returns of a market index, enhanced indexing seeks to exceed index performance, generally within some pre-specified risk parameters. Enhancements are generally achieved in two ways:
q by the use of index futures in combination with other non-stock instruments; and
q by using a different combination of stocks, usually fewer, and different weighting schemes than the index. The latter method generally requires greater ‘tracking error’ tolerances and aspires to add greater incremental return.
Tracking error, a method of calculating the normalised deviation between index and portfolio returns, is a key determinant in selecting an enhanced index strategy. Generally, investors must agree to a trade-off between return enhancement goals and tracking error. The tighter the agreed-upon tracking error, the lower the opportunity for the manager to attempt to add incremental returns. The reverse is also true. Two other statistics needed to comprehend the world of enhanced indexing are ‘alpha’ and ‘information ratio’. Alpha is a measurement of excess returns over the target index, adjusted for systematic market risk assumed relative to the index. The information ratio is calculated by dividing alpha by the standard deviation of portfolio returns. It is a measure of efficiency, the higher the information ratio, the better.
In conversations with US plan sponsors, three reasons for selecting enhanced index managers seemed most prominent. One is specific accountability; measuring and explaining the degree of excess return contributed by the manager is transparent and unambiguous. The second reason is risk management; investors can depend on the manager staying within track error boundaries. The most compelling reason cited may be the expected combination of reliable performance and relatively low fees.
Data on institutional asset managers provided courtesy of Plan Sponsor Network (PSN), of Port Chester, NY, illustrate this point. PSN identified 74 enhanced index managers benchmarked to the S&P 500 in its database with at least 10 years of history. The range of annualised returns for these managers for the 10-year period ending 31 March had a high of 17.5% and a low of 13.4% in contrast to 13.3% for the index. Hence, all 74 enhanced index managers achieved their goals. The median manager for this time frame returned 14.3% or 100 basis points more than the index. For the five-year period ending the same date, the median enhanced manager returned 10.9% in comparison to 10.1%. The index, however, did manage to find its way into the fourth quartile since two managers underperformed it in this time frame. In total, plan sponsors included in the database had $172bn (e182bn) in these products.
So, considerable evidence exists for employing enhanced indexing strategies on the bases of consistency, efficacy and low fees. But, these figures all pertain to the large-cap US market – the most efficient stock market in the world. Do enhanced index strategies also make sense in less efficient markets? In the small-cap US market, 60% of the enhanced index managers outperformed the Russell 2000 over the five-year time frame. In the handful of enhanced index products in the Europe ex-UK region, the enhanced index manager outperformed by an annualised average of 55 basis points over five years. However, the sample is small and not statistically significant. Steven Schoenfeld, managing director of Barclays Global Investors, a leader in enhanced indexing assets under management, believes that this trend is no fluke. As more sponsors become aware of its benefits, Schoenfeld predicts, “…enhanced index products will enjoy the same sweet spot in international markets that it does in the US”.
Synthetic strategies, where the enhancements are entirely independent of the stocks in the index, are generally the most conservative approaches to enhanced indexing. One of the foremost practitioners in the US is California-based Pimco. Synthetic index strategies are the only equity-equivalent products offered by Pimco, marketed under the name ‘StocksPLUS’. According to senior vice president Sabrina Callin, Pimco has offered these products since July 1986, most popularly on the S&P 500 index. With $18bn under management as of March 2002, StocksPLUS is among the world’s largest enhanced index products.
A thumbnail sketch of the inner workings of StocksPLUS provides some insight. Each account will initially invest 5% of its assets in US Treasury bills to cover its initial futures margins, and 20% in overnight securities to cover the variation margins associated with futures market fluctuations. The remaining 75% is invested in fixed income instruments of durations between three months and one year. All such instruments must possess a S&P credit rating of no lower than A. Callin adds, “Most customers are attracted by the product’s consistency in generating excess returns. Since inception, StocksPLUS has outperformed the S&P 500 in 166 of 177 rolling 12-month periods, and 100% of rolling 36-month periods.” During that period, the average magnitude of excess return has been 153bps (before fees) a year. Other prominent practitioners of this basic strategy include Northern Trust Global Investments of Chicago and First Quadrant Corporation of Pasadena.
A currency overlay is another potential source of incremental return. One of the leading currency overlay specialists is Connecticut-based AG Bisset & Co. Half of its clients and 67% of its assets are European-based.Says Ulf Lindahl, Bisset’s managing director, “Currency overlay has been popular in Europe for a while and is now beginning to catch on more in the US. Recent studies by research consultants Intersec and Callan Associates reflect consistent alphas from currency overlays.”
Stock-driven alpha strategies are among the most common approaches to enhanced indexing. Generally speaking, the concept is to create a new equity portfolio that the manager expects to deliver better returns than the benchmark, while maintaining very similar systematic risk exposures. The equity positions of these portfolios are generally dominated by stocks that are contained in the index, albeit with different weightings. However, although most of the stocks in the enhanced index portfolio generally are also members of the index, the converse is not true. Most enhanced portfolios attempt to maintain fewer positions than the benchmarks, thus many of the index’s smaller positions, chiefly those that the manager do not expect to be sources of incremental alpha, are not included. Most practitioners employ two major tools to construct the enhanced portfolio: an optimiser and an ‘alpha’ file.
Rick Roberts, marketing director of First Quadrant, says: “Enhanced indexing is managing incremental active risk (tracking error) while maintaining the target portfolio’s main economic exposures.” Risk exposures are determined by the specific optimiser used by the manager.
BARRA, based in Berkeley, has the largest market penetration, and is also the oldest surviving provider of optimisation software. Its systematic risk measurements, based upon classic modern portfolio theory principles, represent market factors such as price-to-earnings ratio, industry exposure and dividend yield. APT, based in New York, uses global and macroeconomic factors to interpret systematic risk. New Frontier, often coupled with veteran distributor Northfield Information Systems, is the newest and fastest-growing entrant in the optimisation field. It uses a technique called resampled efficiency to reflect the fact that historical returns are not true probability distributions. Enhanced index managers using this model have a tendency toward portfolios with less turnover. Among the three optimisers, the differences are about the techniques used to define and manage risk. They do not affect the determination of expected incremental return.
This is determined by the ‘alpha file’, an array representing the projected relative attractiveness of the stocks available for selection. Sometimes the alpha file represents one characteristic (for example, yield, price/earnings ratio, projected earnings growth) for each stock. These portfolios are generally referred to as being ‘tilted’ toward a particular characteristic, such as a yield tilt or a growth tilt. Alpha files can also be more complex. They can also combine quantitative data with quantifiable qualitative data, such as research ratings. Once the alpha file is determined, an optimised portfolio is created by determining the highest position-weighted aggregate alpha that can be derived while satisfying all explicit portfolio constraints and keeping projected tracking error under the maximum acceptable tolerance. Using an aeroplane as an analogy, the optimiser can be thought of as a stabiliser keeping the trajectory on course. In this context, the alpha file is the power source or thrust. This is the file from which return enhancements must be derived.
Another leading global practitioner is State Street Global Advisors, headquartered in Boston. According to London-based group chief investment officer Alan Brown: “Given arbitrage opportunities come and go and provide no consistency in performance, we provide the forecast-based strategies with a heavy emphasis on stocks.” These strategies have been in use for broad-based indexes since 1993. In addition to the US broad- based indexes, the strategies apply to the Euro Stoxx50 and FTSE All Share indices. SSgA makes a conscious effort to steer away from narrow indexes, especially the FTSE 100. As of February 2002, there were 275 stocks in the portfolio benchmarked to the S&P 500 and 750-800 stocks benchmarked to the MSCI World index. SSGA has $5.3bn under management covered by these strategies.
For State Street, the goal is to add 50–100bps of excess return to the benchmarked indexes, namely S&P 500 and MSCI-World ex-US. Brown believes consistency in generating excess returns is of paramount importance in physical stock strategies.
As if they didn’t have enough problems consistently beating a passive benchmarks, European active managers will apparently have increased competition from enhanced indexers. Of the 12 US managers we polled, 10 expected to offer either a Europe-only and/or a Europe ex-UK product before the end of next year. If enhanced index products continue to combine consistent outperformance with low fees, it appears that an increasing onus will be placed on active managers to justify their continued employment.
Herbert Blank and Pauline Lam are with QED International Associates in New York