Rick Lacaille, head of the structured product group at State Street Global Advisors is optimistic about the long-term growth prospects for indexing across the Europe – despite the current market turmoil.
For Lacaille, the gradual shift by European pension funds from fixed income into equity is part of the same story as the move toward indexation.
“It’s hard to detect whether this trend is speeding up or slowing down at the moment, but indexation is part of that general equation,” says Lacaille.
State Street is among a number of large international providers carefully tracking the growth of indexation in Europe and competing with local rivals for a slice of the passive pie.
Lacaille believes the potential growth extends even to the UK, where passive is very much part of the landscape and already dominated by three big index players, State Street, Barclays Global Investors (BGI) and Legal & General.
“In the UK, the institutional market is pretty mature in terms of indexing, but the retail sector is not. In Europe, the institutional index market is not mature at all.”
Lacaille says that while State Street remains cautious that the US bubble may not have fully unravelled and that markets have further to fall, this is not inconsistent with faith in indexing going forward: “We feel that many clients will still be well served by that choice.
“For example, we still see UK pension funds going indexed and we are still gaining clients from traditional active managers, some of whom are having performance difficulties that, of course, affect their clients in a bear market.”
However, he cites Germany as the market where the most new money is currently moving towards passive investment.
Certainly, in the post Riester reform environment, German institutions are able to think more liberally about their investments. According to a recent survey by consultants Feri Trust, passive investment is growing slowly but surely, although the consensus is that it will take years for institutions to have the kind of passive weightings that are usual in the Anglo-Saxon markets. However, awareness of index investment and the cost differentials with active management, alongside interest in benchmarks, has grown immensely in the last few years.
As a result, the core passive/active satellite debate is getting a much wider hearing in the German market. Jens Pongratz, investment consultant at Buck Heissmann, says German clients are now well aware of passive management: “Regarding bonds, most institutions feel that it is OK to use passive management. One of the main issues is cost, and passive is so cheap, so they really like that.
“With equities I think the main focus is still more on active management. Enhanced indexation is also discussed, but more on the fixed income side.”
In terms of providers in the German market, Pongratz notes that not everybody is offering index products: “We are usually referring interested clients to the international providers like State Street – who are quite strong here in Germany. Allianz Dresdner is also offering passive products.”
The Netherlands remains a market where index tracking is a major part of pension fund exposure and consultant. Henk Klein Haneveld, managing director of Klein Haneveld Consulting, sees this market continuing to grow.
“Passive approaches are being implemented by a larger number of pension funds and so market share in terms of numbers is growing.
Haneveld approximates that funds that do go passive typically invest at least a quarter or more of their assets.
Interestingly though, the consultant also notes that there has been something of a counter movement away from passive amongst some of Holland’s largest schemes.
“Big pension funds like ABP have been reversing away from passive management towards more active management. They are building up their own investment department in which they are looking to catch more positive alpha. This can mean that the overall flows into passive in the Netherlands don’t always look so big.”
According to Haneveld, US manager Vanguard is enjoying the fastest growth in market share of late: “Vanguard has built up assets very quickly from a low base, although of course State Street and BGI were here earlier in the market and have a bigger market share.
“As far as the Dutch players are concerned, I don’t see much change. There are only very few Dutch investment managers that provide passive investment products.”
The Belgian market is another where the shift to a core passive focus amongst pension funds is already reasonably well developed.
Johan Heymanns, director at consultant Watson Wyatt in Brussels says the country’s larger pension funds have all considered how to bring passive strategies into their risk budget.
“What pension funds are doing is to concentrate their risk budget in an area where there is a high possibility of gaining an extra return.
“So we see a trend for instance to not spend any more of that risk budget on European government bonds because doing active management on European government bonds is extremely difficult. There is a tendency to go for those types of investments via a passive approach. On the other hand for credits active management can still work, so investors prefer to have more active involvement here. It’s the same with emerging markets.”
For equities, however, Heymanns notes that the passive approach is less prevalent: “Pension funds could have the same approach with a large core passive exposure and then highly active small cap investments, but in the Belgian market there is less focus on this type of arrangement compared to other countries.”
Heymanns notes that all the large Belgian managers are starting to develop products in the passive area to compete with the big foreign houses.
“KBC, for example, has come out with a range of products under a different name because they don’t want to miss out on the passive business potential.
“Most of the other local players also have their own index products, but for the bigger indexed mandates it remains the likes of State Street and Deutsche that have been appointed.”
The growth in index investment in Ireland has been little short of breathtaking in the last five years, as Tom Murphy at Mercer in Dublin, comments: “About five years ago investment in passive would have been fairly low – less than 5% of the market – but the last IAPF survey showed that it was now about 20%, so the market has grown quite substantially.”
But Murphy points out that some Irish managers were wise to the trend and have managed to corner much of the business.
“Irish Life now has around e6bn in passive assets and that would have been from a standing start, so they have taken a fair chunk of the Irish market. At the same time, State Street and BGI have been reasonably busy, with Bank of Ireland fronting State Street’s business and BGI picking up some of the larger passive mandates over the last three to four years.
“More recently, Legal & General have shown an interest in the market by bringing some of their unitised products over that they have available to UK clients.” Murphy believes that if there is an overall trend in the investment of Irish pension funds, then it is towards the core/satellite structure.
“The Irish market to some extent is still playing catch up to the UK/US markets and trustees that have been on the active/balanced merry go round are now stepping off and looking at passive.
“As such, passive tends to be more on the radar screen than it was. But, given the current market environment, I think a lot of trustees are looking at those kinds of issues but not implementing anything. I think they are holding off until they see some kind of stability in returns in the market.”
In terms of interest in enhanced indexation, Murphy says there has not been a huge demand to date, but sees some shoots of interest.
“Many people are starting to say that if there is one or two smart things you can do then there might be some value to be added, but I think its very early days for that product and it hasn’t really been touted in the Irish market.”
Sven Ebeling at Swiss consultant, Ecofin, explains that the Swiss market is dominated by State Street, Credit Suisse and Pictet,
“When we screen the market we end up with these three providers basically. UBS has a well-known mutual fund indexing Swiss equities, but on the institutional side they are not pushing the business, although I believe they are still doing some indexing out of London.”
Sverker Lindstrom, managing director at Stockholm-based consultant, Lindstrom & Partners, says the presence in Sweden of what he calls the ‘usual suspects’ – BGI, State Street and UBS – has begun to be felt as Swedish institutions turn away from active management on the back of poor performance, which has seen many schemes lose up to half their value.
As part of a core/satellite appraisal in response to the market downturn, Lindstrom says Swedish funds are looking at passive as well as guaranteed products such as index linked bonds: “We see much of these core type arrangements coming in, but we don’t see much of the ‘satellite’ yet. I think investors are waiting to see what satellite approaches can actually deliver the alpha they need.
Significantly, Lindstrom points out that the local managers cannot afford to look at passive management as a competitive option against the bulk passive players. “The Swedish banks all need their 1-2% in active management fees in order to survive!”
The message then is that passive investment is here to stay in Europe and its impact on the shape of the continent’s fund management could be significant.
Where local providers react early enough and use their home advantage, they can compete well with their international rivals. Where they don’t, the impact on their business could be fatal. Some already need to get wise to what is happening before it’s too late.