A rare sight for a pension fund to behold of late is it's money managers outperforming the benchmark, particularly in efficient markets. Act-ive management is a growing source of disappointment for those running pension funds, who are not only fed up with their managers' shortcomings, but are equally so by the costs to their fund each time they hire and fire managers. Not surprisingly there has followed an explosion in popularity of indexation techniques in the UK in particular, with the rest of Europe not too far behind.
Gartmore, which holds £14bn ($23bn) in indexed assets, and which has become better known in the business following the NatWest takeover, has recently scooped six UK indexed mandates for Thomson Travel, Brittannia Airways, Andrew Industries, Bronnley & Co, Banco Bilbao Vizcaya and Aspen Communications. Ian Martin, head of business development at Gartmore in London ascribes the interest to a revolt against underperforming managers. The top five managers have failed to deliver really against people's expectations."
He adds: "Last year, active managers beat indices, this year they didn't and that's the nature of the beast really."
An indexed fund manager essentially imitates the trading patterns on a given stock market and attempts to replicate the same results within his own fund, without taking a position in respect to any individual securities. And while active managers have difficult acts to follow when attempting to beat the index, there is no less skill involved in matching it either, says Jon Hunt, senior vice president at Northern Trust in Chicago. "The skill of the index manager is managed by the tracking error - how close can you get to the index? In some indices the expectation is a basis point and that is really tight. In other indices, the expectation may be 10-15 or even 40 basis points and some of the key as-pects that enter into your ability to do it is what are your trading costs?"
He adds: "If you incur an eighth of a point in trading costs that's 12 basis points tracking error and that can be a big number."
Such a skill is best exploited in the world's most efficient markets, where only a fraction of active managers are likely to beat the index. In the US, the large cap market remains one of its most efficient, and over the past 10 years it has beaten approximately 80% of active managers. The reason being, is that over the past three years, the market has been largely dominated by the 50 largest stocks, including the likes of Intel, GE and Coca Cola, who have had a disproportionate share of the market increase in capitalisation.
"Unless an active manager holds in-dex weights or higher than index weights on that handful of stocks, there is almost physically no way that they can outperform the index," says Hunt,. "Those 50 stocks are widely analysed, understood and evaluated by the analysts, so it is pretty hard for an active manager to claim to know more about GE than anybody else."
Of course, index funds will only de-liver good results when the market does. If the market suddenly drops, it will pull the index fund down faster than an active manager holding lesser or no weightings in those stocks, so investors sticking with an active manager have a fairer chance of survival.
"Being an index manager is more favourable when the market moves up," says Hunt. "Being an active manager is more beneficial when the market is going down."
Northern Trust is in the process of acquiring the American National Bank Investment Company, also based in Chicago. After the takeover, Northern Trust's current sum of $13bn managed in index products will explode to $48bn, placing the bank firmly in the world's top five in indexation investments behind Barclays Global Investors and State Street. And the funds which are currently not available to non-US investors, will be marketed into Europe this year. Both Hunt and Martin see the pensions crisis in Europe and the emergence of defined contribution as key factors which will aid indexed funds' progress.
Hunt explains: "There is a huge gap in unfunded retirement and pensions liabilties in Europe. One of the reasons is that there is a restriction on non-domestic equity holdings. As pension funding crisis looms larger, you're going to see government agencies saying to the likes of Nestlé and BMW - if you are going to sponsor and close that liability gap, we're going to have to give you the ability to invest in other asset classes that have different risk and return characteristics.
"One of the next logical steps is how are you going to get that exposure relatively inexpensively."
US pension plans commonly break down the fund into two parts - the first portion aimed at achieving exposure to certain asset classes, with the second, and notably smaller portion allocated to achieve outperformance of the indices. "That has been adopted by a number of very large plan sponsors and some mid-sized ones as well in the US," says Hunt.
Northern Trust does not hold in-dexed products in individual non-US markets, but instead groups them as EAFE for investors who want exposure to such stocks. However, while the S&P 500 is a complete representation of the US large cap market, EAFE does not represent the entire European, Australasia and Pacific markets, not to mention the fact that 90% of active managers have outperformed it over the past five years.
As such, Hunt sees the US index business developing more individual country indices, keeping the multinational client very much in mind. Except for the time being, costs do not allow. "A provider has to be able to provide an awful lot of those to meet the needs of a multinational plan," he says, adding "If I was in Germany and wanted exposure to an index that was Europe ex-Germany, how do I build that? You could say it is either a subset of EAFE or it is the sum of Paris, London, Rome, Lisbon and Madrid - which way is the easiest way to build that and the cheapest? It's the subset of EAFE.""