The growth of securities indexing has been one of the most significant investment trends over the past decade. In times of bear markets its value is regularly questioned, but indexation has an established place in institutional investment and continues to develop as a tool for investors. So what has been the engine of this growth and what does the future of indexing hold?
How indexation established itself
The acceptance of indexing as a core component of a well-diversified portfolio – and a complement to active managers – can be attributed to several factors.
Risk budgeting is a key concern for institutional investors, both the total risk of their investment portfolio (which may hold several different asset classes and many managers within those asset classes) and relative or active risk, which relates to the variation between the benchmark to which a manager is held accountable, and what actually may transpire. The only way a manager can eliminate active risk is to fully replicate the underlying benchmark, which is precisely what most index managers try to do.
Indexing has provided many institutions with new techniques in ‘plugging risk holes’ in active portfolio groupings through the use of specialised index accounts. For example, an overall investment plan may have a broad-based equity benchmark like the Russell 3000, yet also have a collection of active managers who hold a disproportionate concentration of large-capitalisation stocks. Small and large capitalisation index funds can be used to diversify these holdings and attain broader exposure in line with the stated broad-capitalisation benchmark.
The management fees charged by a manager, whether active or index, can be highly variable and are based upon a combination of elements. Typically, an index manager will charge lower fees than an active manager. Some of the more obvious savings come from differentials such as research and internal costs, portfolio turnover, and securities crossing.

Modern use of indexation: core satellite
Traditionally, indexing has often been viewed as a ‘rejection’ of the concept of active investing, thus setting up the great ‘index versus active’ debate. On the indexing side of this debate are those who note that the average participant in the markets, including active managers, will achieve only the performance of the market average itself. Further, after accounting for the drag of management fees and trading costs, traditional active management is, on average, a ‘losers game’. On the other side of the debate are the traditionalists who disdain the indexer’s purposeful effort to be ‘just average’, and see active management as valuable wherever there might be inefficiency – which is everywhere.
Many investors have dismissed this argument and use index funds to provide a core, risk-neutral position in one or more asset classes around which ‘satellite’ active managers can be added. In this structure the index fund can be counted on to deliver benchmark returns while the active managers are expected to add value above their relevant benchmark. Frequently, the existence of the index fund with its market-level risk, prompts the investor to give the active manager(s) a higher risk mandate than would be the case without the index fund. However, this is not actually the optimal solution. In all cases, using strong managers that have lower active risk is preferable to managers with higher active risk.
The new approach involves estimating the ‘optimal’ combination of managers. This optimisation approach looks at the combination of managers as a portfolio, one that should have desirable risk and return characteristics in sum, rather than taken one manager at a time. The objective function of this optimisation is to maximise the portfolio’s expected alpha while controlling its active risk. This ‘manager structure optimisation’ or ‘risk budgeting’ approach rejects the index versus active debate by combining the two to serve the investment objectives of the fund.
Indexation in asset allocation
Indexing is also being used more and more as part of asset allocation overlay. One of the traditional dilemmas that institutional sponsors have encountered in the management of portfolios has been the burden of cost control in timely and nimble asset allocation changes. Portfolio disruption caused by reassigning mandates among various manager mixes due to performance differentials between asset classes has been a drawback in maintaining close adherence to a strategic or policy asset mix. For that reason, many large institutions have let their actual asset allocation drift significantly from stated policy benchmarks, the costs of rebalancing being too intrusive on overall returns. This has resulted in asset mixes that differ significantly from long-term objectives.
The relatively low costs attached to index management have led it to become a useful solution to this asset allocation challenge. Institutions that maintain core index positions in broad asset classes can rebalance to their stated benchmarks by simply reassigning asset surpluses into temporary index accounts that adjust asset exposure while awaiting assignment to managers. This can be accomplished through index funds or by using index derivatives as an overlay to the existing account balances.
Another feature of index funds in the management of asset allocation involves their tactical use as a method of enhancing total performance while reducing plan risk. Once again, low-cost index funds or index derivatives can be employed to temporarily alter the overall plan asset allocation if the relative risk-adjusted expected return of one asset class outweighs another. This tactical adjustment can capture these modified outcomes without disrupting the performance characteristics of the existing manager mix.

Indexation embraced by institutions and individuals – ETFs
Exchange traded funds (ETFs) are one of the fastest growing index investment vehicles used by institutional and individual investors. ETFs are similar in nature to index mutual funds in that they provide investors with exposure to broad market segments with very low tracking risk, but they have several additional characteristics that have led to the increased popularity and diversity we have seen over the past five years.
Unlike traditional mutual funds where investors can only purchase or redeem their units at the close of the trading day ETFs can be bought or sold throughout the day, thus providing investors with intra-day liquidity. This feature enables investors to implement various investment/trading strategies using ETFs that would otherwise be impossible solely using mutual funds.
ETFs have a lower expense ratio than most mutual funds. This is because ETFs incur fewer transactions due to the unit redemption/creation process. US ETFs also have greater tax efficiency than traditional mutual funds. All ETFs are listed on an exchange which means investors can transact these funds from their existing brokerage accounts.
Given the breadth and depth of their coverage, ETFs can be used to implement multiple regional, country or sector overlays, as well as various completion strategies. They can also be utilised in transition management, providing market exposure through a manager transition.
Growth of ETFs continues to be strong and the advent of new products such as fixed income ETFs have been received well in the institutional and individual investor markets.
Flexibility with derivatives
Another area of growth has been in the use of index futures. Rather than requiring investors interested in index replication to hold all constituent securities in an underlying benchmark, index futures trade as a package instrument representing the total return of an index or security basket and can greatly reduce trading costs. The futures holder is responsible for maintaining a margin deposit on a fraction of the underlying notional value of the investment as well as covering changes in its value.
Trading volumes in futures markets have exploded over the past 15 years and generally provide the marketplace with an additional dimension of liquidity in portfolio management.
Index futures can be used to ensure efficient portfolio management by allowing the manager to ‘equitise’ smaller levels of cash accrued by dividend revenue or new client money, keeping the portfolio tightly committed to the benchmark.
Index futures can also be effectively incorporated in a strategic plan as an adjunct to another interesting, relatively new investment strategy. Recently, many institutional investors have taken advantage of alternative investments, to add a new dimension to their standard asset class exposure. By using futures contracts, hedge fund managers’ returns can be attached to a particular asset class by tying it to exposure via long futures contracts in the asset class.
Evolution continues
We believe indexing will likely be the foundation on which the investment strategies of the future are based, and the level of sophistication in combining global indexing with active management will undoubtedly increase going forward. Although there are critics of indexing, no one will deny the impact that its growth has had on the investment industry as a whole. The key benefits of indexing – in performance measurement, cost control, reduced portfolio turnover and flexibility – will continue into the future.
There has been a tremendous evolution in the use of indexation over the past 30 years. One concept seems timeless, however, and that is indexation should not be viewed strictly as a substitute for active management, but rather as an effective tool in a holistic investment strategy that attempts to invest in broad universes of assets and asset classes.
Matt Scanlan is head of business development, US institutional business, for Barclays Global Investors