Index funds play an important role for pension funds in the Netherlands.
Larger funds in particular have invested a significant part of their equity portfolios in passive products. Even indexed fixed income funds show growth both in new funds as well as in absolute figures.
Experienced investment managers have realised over time that the major driver of long-term return of institutional investment funds is the allocation of funds to different asset classes. The decision as to how much goes to equities or bonds or to different equity markets can account for up to 90% of the total return of a portfolio, while investing in specific securities adds only 5%.
Active management can be less successful in efficient markets - well researched and highly liquid capital markets - and active managers have not demonstrated any consistent skill in outperforming the market averages. Consequently, indexing is very appropriate in these circumstances, especially as index funds benefit further from their well recognised low management fees and custodial expenses and the securities lending revenue that they are able to generate.
Other advantages of index funds include lower risk through broad diversification, much lower transaction costs, easier asset class and country allocation and reduced administration for the investor. Index funds experience lower volatility than actively managed accounts. Despite the larger number of stocks held in an index portfolio, it can be more easily liquidated or purchased at a fraction of the cost of more concentrated accounts.
Index fund managers also cross their clients buying and selling investment activity, usually carrying this out at no cost to the client. In larger markets this can sometimes be as high as 90% of all transactions. Buying and selling an index can cost as little as 0.25% of the portfolio value, while in a comparable active portfolio this can be two or three times higher.
The sole advantage in active management is the prospect of a higher return. Generally, active managers look to add return between 1-2% a year above the index. Of course, the reality and the risk of active management means that most managers - 85% over the past year in the US - fail to beat the market. Over long periods the average active manager has underperformed index returns by 2% a year after expenses.
Furthermore, the fact that successful managers gain only at the expense of other active managers leads to the conclusion that, at best, only half of all active managers will beat the market over any time interval. And that is before fees which usually lie between 0.3% and 0.4%.
Consequently any allocation to active managers must be premised on the sponsor’s ability to select above-average performing managers given risk and expenses.
Dutch pension funds have started to adapt passive managementfor the above mentioned reasons and index funds will continue to have a growing and important function in pension portfolios as plan sponsors continue to find that active managers fall short in their demands.
Other quantitative techniques are gaining significant appeal here and it is interesting to note that, unlike the UK where investors have not looked beyond indexing, Dutch pension funds are now gaining confidence to move towards the next generation of quantitative techniques such as tactical asset allocation and enhanced index portfolios.