The Dutch institutional market is renowned for its forward-looking, practical and sophisticated approach to asset management. It is hardly surprising, therefore, that this group of investors came early to the indexing party, at least for part of their equity portfolios. Events that led to this were a rapid increase in pension fund assets and a recognition that greater equity exposure was an imperative to improve bottom line performance for the plan sponsors. With a limited domestic marketplace and large pools of money to invest, what better way was there to achieve a risk-controlled, highly diversified portfolio and where investment returns were not a lottery, than by choosing to match the index performance. Of special appeal to a nation that believes in value for money is the fact that the costs are low!
The first fund to venture into this new field in 1985 was PGGM which today indexes 30–40% of its equity portfolios. Other major funds followed suit and now it is the turn of the medium size funds, which are facing the squeeze of finding and affording the right people, to incorporate indexation into their strategies, won over by the same arguments. Today, the total money committed to equity index portfolios is estimated to be around E55bn, placing the Dutch squarely in third place behind the US and the UK. These index portfolios are almost entirely outsourced, the advantages of using a specialist being difficult to fault, in a business where cost saving is so important.
There is no pattern to how index funds are employed – there are as many different strategies as there are pension funds – but the one common theme is a recognition that the risks of traditional active management can be better managed if there is a core index base to the portfolio. Some plan sponsors have chosen to index across the board, others use it in those markets where good active managers are difficult to find – US equities being a particular case in point. A third group sees indexation as giving them a benchmark for their active managers while yet others use their index portfolios as a way to implement their own asset allocation decisions easily in a cost-effective and flexible manner, leaving their active portfolio managers undisturbed. Almost all accept the virtues of being in a pooled fund – cost savings being a major driving force.
Dutch pension funds have almost always chosen MSCI as their benchmark for non-US equities, while the S&P 500 is widely accepted as the preferred benchmark for American equities. A few investors have chosen to track the FT/S&P index series. Interestingly, when considering benchmarks for Dutch domestic equities, pension funds do not seem to feel obliged to use either of the main domestic indices. It is hard to know whether this is simply an acceptance that index returns are, in reality, quite close or whether it is simply because it maps to the liquidity of trading index-like portfolios with investors elsewhere in the world.
Where does index management in the Netherlands go from here? Unexpectedly, one of the earliest manifestations of the impact of the euro is the search for index managers who can offer Euro-zone fixed income index portfolios. The preoccupation of a number of the larger funds at present is to find managers who have a strong record of non-domestic fixed income markets and, more importantly, have been used to managing outside the government sector – an area where local expertise is thin on the ground. Here, the ability to deliver ‘smart indexing’ is drawing a number of supporters.
On the equity side, many were predicting that the introduction of the euro would precipitate a rush to invest in sector indices. But there seems now to be a recognition that while this might eventually be the case, using sectors alone as a benchmark to manage a European portfolio is an idea whose time has still to come. Individual country considerations will continue to provide the dominant influence on security pricing for the short to medium term.
Another trend that has met with increasing acceptance by Dutch funds already comfortable with an index portfolio is to assign part of their equity assets to so-called “enhanced” index funds – that is to say, portfolios whose main characteristics still mimic the index but which are tilted towards certain factors such as earnings expectations, value signals or other quantitatively derived factors. The plan sponsor is still keeping tight control over risk but is seeking to add just a little bit over and above the index return.
Most recently, some have caught the press stories in the UK and started to worry if there is too much indexing and what long-term effects this might have on their returns. But the arguments put forward by the anti-index lobby can be readily countered – indexing is still a small part of the total market, its benefits are manifest to anyone who has undergone the experience of a poor performing manager. Dutch pension funds who can understand this continue to demonstrate their forward-looking, practical and sophisticated approach to asset management.
Hilary Smith is managing director at Barclays Global Investors in the Netherlands