Indexing comes out of the closet
So what was it all about? We returned from our New Year breaks and the office still functioned, the computer switched on and programs operated as usual – that is, my system still froze as often as it used to. Business as usual.
The concerns that we had at the end of 1999 are still here in 2000. Nothing has gone away. The markets go up and the markets go down and in January they have done so with a vengeance. One of the stories that just will not go away however is the move of the pension fund industry towards greater adoption of indexation asset management.
Now at the moment this story is, essentially, an Anglo-Saxon one. US and UK pension funds make much greater use of equity indexation than funds in other countries, although Swiss and Dutch pension funds are not too far behind. Leading consultants, Watson Wyatt however forecast that 30% of institutional equities managed in the UK will be indexed by the end of 2002. This compares with an estimate of 15% of Swiss funds and 12% of Dutch funds. Indeed, William M Mercer is quoted as saying that in 1998, 49% of all new money coming into UK pension funds was claimed by passive managers.
It is interesting to analyse just why this has happened. The consensus of opinion is that indexation has grown because active managers, on average, have failed to provide consistently good performance. This is true, but I believe it is only part of the story. Funds have many reasons to index at least part of their portfolios and a conference recently held by our firm gave some very interesting insights into their reasoning. A panel of four pension funds described why they had moved a large part of their assets into indexed funds. The thinking varied tremendously.
The move to indexation was made for the obvious defensive reasons after performance had suffered, but it was also adopted after active managers had produced sparkling outperformance. It is also interesting to see that pension funds (and some managers) are beginning to see that paying active fees for closet indexing just does not make sense.
Watson Wyatt has been pushing its passive/active core and satellite models for nearly two years now and has met with reasonable success. This has meant some renegotiation of fee structures. Passive fees are much lower, but real specialist active management has to be paid for. Nevertheless funds moving to a large passive core with active satellites have still found that they can save money on fees. In addition they can get better risk control and the possibility of overall (but limited) outperformance. The possibility is therefore that funds obtain better net performance per unit of risk.
Frank Satterthwaite of leading US fund manager Vanguard has explored some of the great myths about indexation. One of the biggest is that active managers outperform in bear markets. Therefore if one expects a bear market one should not be indexed. Satterthwaite's research shows however that active managers in general have not been very successful in the market crashes of the past, if one recognises that the ability to get back into a market at the bottom is every bit as important as the decision to get out at the top.
It comes as no surprise to me that managers are not good at timing both directions. Indeed quite a number of managers manage to get it wrong altogether. I can think of a number of instances where managers have been fully invested at the top of the market, selling into the decline such that they held their maximum amount of cash at the very bottom and were therefore far too late to reinvest.
At the end of the day we do need manager skills. If market timing is not a skill many fund managers possess let us hope the majority can pick stocks. What greater adoption of proper indexation can do is free managers to concentrate on their skills and forget about closet indexation.
I would like to see more specialist appointments and greater adoption of riskier and potentially more rewarding satellite appointments. The key of course is to balance risk and reward and one of the best approaches is to have a broad mix of skills. I hope that the adoption of indexed assets as a core will lead to the appointment of the full spectrum of other asset strategies, including hedge funds and private equity.
Now I appreciate that for many pension funds the administration will prove too much and the only answer will be to go to a one-stop shop. A good example of this is Deutsche Asset Management, an active firm with an impressive track record in so many areas. Deutsche Bank recently bought Bankers Trust and inherited a sizeable index business. It now has a huge challenge, one that has defeated other companies, in successfully combining the traditional active and newer passive approaches.
Trevor Cook is managing director of Specialist Pension Services and director of The European Pension Fund Investment Forum