Index fund management is now in the mainstream of the investment world. We expect it to have an even bigger part to play in future. It will continue to shape investors’ approaches to risk budgeting and asset allocation, and the lessons learnt from successful index management will continue to help shape the future of active fund management.
As recently as 1990, indexing was an uncommon investment strategy in European countries where it is now commonplace, such as the Netherlands and the UK. Just over one in 10 pension schemes in the UK, for example, used indexing as part of their portfolio, according to National Association of Pension Funds (NAPF) surveys. Now, nearly half have assets in an index-tracking fund. Last year’s Myners Review of institutional investment found that indexing accounts for some £350bn (e567bn) of UK institutional assets, around 25% of the institutional market.
Low management fees, ease of manager evaluation and competitive performance against traditional fund managers have all driven the success of indexing. Inconsistent performance by active fund managers during the long bull market of the 1990s played no small part in this success.
At the start of a new century, indexing is being used in increasingly sophisticated and creative ways, especially by institutional investors. Investors increasingly acknowledge that risk can be approached in a purposeful, disciplined way, and that doing so significantly improves consistency in achieving desired investment returns. Our group realised this over 30 years ago when it invented index fund management.
Already a common approach in the US, we expect to see risk budgeting take hold in Europe and elsewhere. By setting clear financial goals for an investment scheme and by assessing the investors’ risk tolerance, it is possible to arrive at a specific level of risk at which a scheme should be managed. That level can be treated as the scheme’s risk budget and portions of that budget can be allocated to a selection of fund managers.
We have found in the US that the benchmark-neutral approach of index funds fits well into the risk budgeting approach. Many plan sponsors use index funds to provide a core, low residual-risk position in one or more asset classes, leaving the rest of their risk budget for ‘satellite’ active managers. 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 frees the plan to give the active manager(s) a higher risk mandate than would be the case without the index fund.
Indexing is increasingly becoming a critical tool as an asset allocation overlay. One of the traditional dilemmas that institutional sponsors have encountered has been cost control during manager or asset allocation changes.
Portfolio disruption caused by reassigning mandates between 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 policy benchmarks; the costs of rebalancing being too intrusive on overall returns. This can result in returns that are different from policy objectives.
The relatively low costs of indexing makes it a useful solution to this problem. Institutions that maintain core index positions in broad asset classes can rebalance to their desired policy asset mix by simply ‘parking’ reassigned assets into temporary index accounts. The asset exposure is then easily adjusted while awaiting assignment to managers.
Portfolio restructuring can be accomplished through index funds or by using index derivatives as an overlay to the existing account balances. These approaches enable institutional investors to maintain a tighter profile to their stated asset allocation policy, without the costs involved in terminating existing asset managers, reducing active manager mandates (placing downward price pressure on their portfolio holdings) or conducting new manager searches for different allocations. If the existing manager mix is performing well, natural plan mis-weightings that occur over the course of time will not have to disrupt managers’ activities.
The success of indexing is forcing traditional active fund managers to re-evaluate their approaches to adding value within the context of sponsor’s focus on risk management. With the coming of risk budgeting, active managers will increasingly be expected to manage portfolios at targeted levels of risk that comply with sponsors’ overall investment design objectives.
We expect the principles learnt from indexing – that risk, return and cost must all be managed to invest successfully – will be reflected in how active fund managers construct their portfolios. Our own ‘advanced active’ process works quantitatively to assess all stocks in an investible universe on a daily basis, and to take small over- and under-weight positions in response to opportunities for outperformance while managing risk relative to the entire universe. In this way we can achieve targeted above-benchmark returns at measurable and specific risk levels.
In the future, all managers will need the capability to invest on the basis of client risk as well as return requirements. Clients will increasingly specify mandates in return and risk terms, and when clients demand 3% active risk, the investment manager will have to be able to deliver.
Another large area of growth for indexing is exchange-traded funds (ETFs). Globally, ETF assets have grown to around $80bn (e90bn), from less than $10bn as recently as 1997, according to Lehman Brothers figures. They offer exposure to an index or market segment, but shares in the fund can be traded just like a regular stock any time the market is open.
Our group is the leading global provider of ETFs, and currently has 12 in Europe under the iShares banner. While iShares in the UK are predominantly aimed at the retail market, it is not hard to envisage a future where institutions are significant users, as they have become in the US and Canada.
ETFs excel as an investment tool because they are flexible, transparent and offer instant diversification. We expect there to be a plethora of ETF’s available to European investors in the near future, representing markets by industry sector, market capitalisation, value and growth stocks in addition to broad-based market indices.
If, as has happened in the US, competition and economies of scale drive annual management fees down to levels as low as nine basis points (the expense ratio for the iShares S&P 500 Index Fund in the US), an explosion of ETF use in the UK and Europe could be on the cards.
ETFs can be used for many of the investment strategies mentioned above: short-term trading strategies to take advantage of fast-moving market trends; long-term investments that track a market inexpensively and efficiently; as portfolio building blocks; as part of a core-satellite strategy; for meeting asset allocation and risk control requirements; or for use in sector rotation techniques.
Despite the increased popularity of indexing, most investment money is still actively managed in traditional styles. There is a large potential for the continued growth of indexing, and as investors continue to develop creative, sophisticated ways to utilise indexed products, the growth in indexing is likely to continue.
The markets in which index funds are most widely used are moving inexorably toward utilising their benefits in tandem with active management to achieve key investment goals – and the debate is no longer about whether to index, but how much.
That strikes us as a much more productive point from which to build long-term, sensible and successful investment strategy.
Patricia Dunn is global chief executive of Barclays Global Investors, based in San Francisco