Equity managers have got more than their fingers burnt recently. Defined benefit pension schemes are maturing and moving into bonds to better match their liabilities, financial economics is questioning the role of equities in even the most immature schemes and individual investors are showing only a limited renewed interest in equities.
The only group who have seemed immune to this trend to date are the index-tracking managers. They continue to take assets from active managers as trustees become disillusioned with the poor performance of their active counterparts. Many trustees, however, although disillusioned by traditional active management feel it must be possible to find someone able to add extra return above the index and don’t feel able to accept the index return. Some of this group are turning to enhanced index management as an alternative.
Another group of pension funds are moving the other way. They already have a large proportion of assets run on by an index tracking manager and are looking for a performance “kicker” from an enhanced approach.
But is either really a strategy that pension funds should be considering? Many managers market their enhanced index strategies by claiming it is a low risk approach to equity fund management. This is somewhat misleading. The strategy does carry a low risk that the assets will perform significantly below the index; however this has almost no bearing on the most important risk to a pension fund; that it will be unable to meet the promises of benefits to its members.
Enhanced indexation is a form of active management that lies at the very lowest end of the spectrum for seeking active returns. It is an alternative to fully active that still has the potential to marginally outperform the index whilst having only a small chance that it will significantly underperform. The precise definition, in terms of risk and return objectives, depends on where you are from. In the US and most of continental Europe, where the active managers are expected to be fairly aggressive, enhanced index managers are asked to achieve returns between 1% and 2% above the index. In the UK, where it is usual to give a truly active manager an objective of this order, it is normal to think of enhanced index management as targeting between 0.5% and 1% above the index.
Enhanced indexation may offer some benefits over traditional active management. Enhanced managers claim they are able to produce returns that are more efficient in terms of a higher return per unit of risk taken. This has been described as the “low hanging fruit effect”, it is easier to pick the fruit that is within reach. Some of the methods used by enhanced managers are different to those employed by most active managers and designed to exploit what they see as more short-term pricing inefficiencies. For example, a manager may choose to gain exposure to a company that has a dual listing (one that is quoted on more than one global stock exchange). Unilever could be one such example. The portfolio manager may wish to establish or increase a holding via the Dutch listed line of the stock rather than through the UK listing if the two prices of this company move out of line with each other. These dual listings can create arbitrage opportunities and this type of strategy has had some success in the past. However, it is debatable if this sort of inefficiency will continue if more investors begin to try to exploit it and a large amount of money is looking to add value through similar methods.
Other enhanced managers take more traditional stock-picking approach, but typically they will focus much more on the trading costs involved in implementing the strategy than most truly active managers.
In the UK, on the whole, enhanced managers have produced returns above the index and this, together with low fees, has meant these strategies have begun to be noticed by pension fund trustees and consultants. In particular, the attraction is in part because enhanced indexation is seen as a low risk approach to equity investment.
This impression of enhanced indexation, and true indexation, being low risk has come about because the parties involved in managing a pension fund have very different risks. Trustee bodies clearly have the ultimate responsibility for the scheme, but will choose to delegate some of the decisions to experts. In particular, they may well retain the decision over the asset allocation of the fund, but delegate the day-to-day management of each asset class and the choice of the underlying securities to a fund manager. The trustees retain the important role of monitoring the fund manager and to assist them in doing this will normally set an index or peer group benchmark. The fund manager, therefore, sees the major risk as being underperformance relative to the benchmark which may well lead to it being terminated from the account. The trustees in their role of monitoring the fund manager will also consider this metric as an important consideration. This has led to the impression that the major risk to the pension fund is that of the investments underperforming the benchmark index. In fact the benchmark was only ever designed to be able assess the fund manager’s expertise. The asset allocation and the assets’ interaction with the liabilities is by far the more important consideration in assessing the true risks of the pension fund.
Index management and enhanced indexation offer a convenient way for a fund to gain exposure to a particular asset class. They offer this with low fees and a reasonable assurance that the performance of the fund will not be too far below, and may even be above, the average active manager.
Enhanced indexation may give incremental returns above the index but this benefit needs to be weighed against the extra costs involved in employing such a manager. The fund management fees may be only slightly higher than for an index-tracking manager, but the extra trustee time needed to choose and to monitor the manager is a significant opportunity cost to the fund. Many trustee bodies have a very limited time to dedicate to the pension fund investment programme and spending it considering the minutiae of the difference between index and enhanced strategies can be considered to be “fiddling while Rome burns”.
Most trustee bodies could spend their time a lot more fruitfully by considering the nature of the liabilities and establishing the risks their investment strategy is taking relative to them. Many sophisticated tools now exist for the evaluation of these risks. Asset-liability modelling gives a long-term view of the possible outcomes of following a particular strategy and some risk management systems give a more short-term view of the interaction of the assets and the liabilities.
If after consideration of these risks, the pension fund wishes to employ an active equity manager, then it makes little sense to employ a manager who is overly constrained on a tracking error measure. Many active managers and all enhanced index managers hold securities that they do not find attractive but not holding them would create an unacceptable risk, for the fund manager, relative to the index. For example, BP makes up around 8% of the FTSE All Share index, a manager who believes BP will underperform may well still hold it at a weight less than 8%, because not holding it is too much of a risk relative to the index. Given that the important considerations for a pension fund have little to do with the index return it is a nonsense for the fund to hold stocks that the expert investment managers considers unattractive. We believe it is better to set the active manager objectives that are more in line with the objectives of the fund and not to overly constrain their investment process with excessive controlling of tracking error, which is almost irrelevant in terms of risk to the fund.
Index tracking and enhanced index strategies in equity markets may have a role to play for some pension funds. But index and enhanced index funds should never be considered low risk by trustees. In most cases, index management offers risk relative to the liabilities that is no lower than the most aggressive active managers.
Matt Gibson is an investment consultant with Hewitt Bacon & Woodrow in London