Eking out extra returns
Melissa Brown, managing director and senior portfolio manager of the quantitative equity group at Goldman Sachs Asset Management (GSAM), says there has been a lot of interest among pension funds in many different markets for enhanced indexation products in the last year or so.
She cites several reasons for the rise of the investment type. After the bear market, return assumptions have come right down, she says. “Sponsors are starting to realise that in order to meet the actuarial assumptions, they’re going to have to find extra returns.”
Enhanced indexing provides a way of boosting returns a little without really changing to overall risks of the plan, says Brown.
On the other hand, active managers have struggled over the past few years. “So the value proposition doesn’t look as strong,” she says. Money is flowing into enhanced indexing mandates from both the pure passive side and the active side.
But just how risky is enhanced indexing as a strategy? Opinions differ as to what exactly constitutes enhanced indexing. And Brown points out that the level of risk involved in enhanced indexing varies according to the country of domicile.
While in the UK it is usual to say that the upper limit of tracking error on enhanced index portfolios was between 1% and 1.5%, in continental Europe, it tends to be 2-3%. In general in the US, a fund with a tracking error of 3% would be enhanced, as long as it has similar volatility characteristics to the benchmark.
So there are problems with defining enhanced indexing too tightly in terms of numbers.“We’d define it as a strategy where tracking error is relatively low,” Brown says.
James Scott, president of Quantitative Management Associates (QMA), which is part of Prudential Investment Management in the US, believes it is a mistake if some investors in Europe see enhanced indexing as a type of passive investment strategy. They are in danger of underestimating the risks if they do categorise it as passive.
“If you look at it in that way, it can get you into trouble. Because enhanced indexing uses strategies and makes bets. It’s more contained, but there’s no guarantee that you’re going to get that return.
“One of the difficulties the whole area has had, is that too many people thought it was a sure thing,” says Scott. “They relied on them (the enhancements) and they were disappointed…they put too much money with the hot manager.”
But enhanced indexing is still growing in popularity in the US, he says, with institutions putting money into it from various different parts of their portfolios. Some investors are pulling back on some of their risk, taking assets away from active managers and handing them over to enhanced index providers, but mostly it comes from the passive side.
“Most of what we’re seeing is from passive to enhanced,” says Scott.
The main benefits enhanced indexing offers pension funds are improved efficiency of their overall portfolio, return consistency, and diversification, says Brown of GSAM. The empirical evidence shows that managers operating at the lower end of the risk scale have delivered higher information ratios, she says, which means the investment type improves the efficiency of your portfolio.
Even though returns are kept within limits by the maximum tracking error allowances, there is a consistency of the return stream, which is important to pension funds.
“Enhanced indexing managers’ excess returns tend to have lower correlation with those of other
kinds of managers,” says Brown.
“So if you’re going to allocate
to an enhanced index manager, there is a diversification benefit there as well.”
Within Europe, there has been a
lot of interest coming from the Netherlands and the UK, with some interest in other countries, including Switzerland and Germany, she says.
GSAM expects to continue offering enhanced index products, and there is the flexibility of being able to create products against many different indices. “There are a lot of different flavours,” says Brown. “We hope to continue to offer flexibility, and to target clients’ risk and benchmark preferences.”
One of the other benefits of enhanced indexation is that the managers tend to make many small bets rather than fewer large ones, which means there is greater capacity than with traditional managers. It also allows managers to reflect negative bets more fully, she says.
GSAM recently won a £110m (e158.5m) UK Quantitative Equity mandate from Shropshire County Pension Fund. This followed a number of wins for the firm’s Quantitative Equity team, the firm said, as pension funds become more aware of the benefits of a risk-managed quantitative investment approach.
With this particular mandate, the objective is to achieve consistent outperformance with a targeted tracking error of 2.5-3%, by combining traditional fundamental analysis with quantitative modelling. The overall performance target is1% net of fees, above the FTSE 350.
Passive management accounts for
a huge slice of the institutional investment market, and enhanced indexing is one of the fastest growing areas within it, says Chris O’Brien, vice-president, marketing and sales, Europe & Asia, at Standard & Poor’s. More than 40% of institutional portfolios in the US are passively managed, 23% in the UK are passive and between 2-6% in
The increase in computer power that is now available is one of the main reasons why enhanced indexing is growing so fast. More can now be achieved on today’s systems.
Indexing has the advantage in that it is considered less risky than active management. However, with all the technological tools that fund managers now have at their disposal, they are asking themselves why wouldn’t they use all that power to increase returns?
In the light of what can now be achieved, pension trustees have been encouraged to push the application of the core satellite model further, says O’Brien.
David Elms, director of market neutral and enhanced equities at Henderson Global Investors, says the key to enhanced indexing for pension funds is where it fits into their risk budgeting. Faced with an overall risk budget, the question the trustees have to ask is, do they want a small amount of risk spread over a large proportion of their portfolio, or a higher risk on a smaller part of the portfolio?
Elms believes that spreading the smaller level of risk over a broader area gives you more return for your risk than the second option. “Enhanced indexing has superior risk-adjusted returns,” he says. “In most markets, it produced consistently better information ratios.”
Even though enhanced indexing
is often confused with passive
management, Elms points out that
it is in fact an active strategy. In
relative terms, the amount of active risk taken is small, but it is still a
strategy that attempts to overweight the best and underweight the
Because of the structure
of equity market indices, enhanced indexing managers actually have a potential performance advantage over active managers, says Elms.
Paradoxically, this advantage derives from the fact that enhanced index managers are limited in the size of the bets they take. Whereas active managers are free to take large bets on stocks, and do, enhanced index managers are limited because of their risk budget.
But because in a typical stock market index only 5% of its stocks are bigger than 1% of the index, an active manager who makes a full-size positive bet on one of these large caps is not always able to implement the corresponding negative bet fully. This is simply because there are so few large stocks.
Enhanced index managers, on the other hand, uss smaller bets, so they do not face the same problem. For them, there are a greater number of bets available. “So the effect is that the enhanced index manager uses the full set of information on negative bets – they can implement a greater proportion of their views on positive and negative bets,” says Elms.
Henderson Global Investors began offering enhanced indexing products in 1997 in the UK. “Since then, it has grown into a global suite of products in a wide range of different indices, and we’re in a position to offer enhanced indexing on any major market,” he says.
There is a range of segregated mandates as well as pooled vehicles. And there will definitely be more to come, says Elms.
It is easier for enhanced indexing managers to succeed in countries where there is familiarity with quantitative methods of investment, such as the Netherlands, Germany and Scandinavia.
While there is significant take-up on enhanced indexing in the UK, investment methods are dominated by fundamental analysis. “You’ve got to be able to understand how an enhanced index provider makes their stock selection,” says Simon Roe, senior investment manager in global enhanced equities at State Street Global
Enhanced indexing offers a variety of things from a pension fund’s point of view, he says. It offers a very low-cost form of active management, lower fees than levied by active managers and the ability to handle very large volumes of assets.
“It is seen by many funds as a key part of the core portfolio,” says Roe. “Enhanced is often replacing a lot
of the passive-run money. Because of the way it is run, it can absorb
very large amounts, which is useful for pension funds.”
It can also add value, so if you have a scheme which is underfunded, the strategy gives you the potential to get some extra returns, he says.
Historically, enhanced indexing has done very well, Roe says,
producing stable and consistent outperformance.
As with other types of investment discipline, no matter how successful a fund manager is at winning mandates, there is only so much money that can be managed. When the assets under management reach a certain level, the manager loses agility in the market, and is unable to move without at the same time swaying market prices.
State Street Global Advisors has come up against this limit in some areas. “For the industry, it enhanced_indexing is a growth area; there are more providers coming into the market. But for us… we’ve hit capacity in certain regions,” says Roe. “If we took any more assets in certain regions, it would be to the detriment of existing_investments.”
In this way, enhanced indexing is like hedge fund strategies – there is only so much you can manage. It is the same for some of the other enhanced index providers which
are also having to close to new money.
This is a measure of State Street Global Advisors’s success in enhanced, according to Roe.