Not just a job for monkeys
In investment, fees are not everything. After all, it is better to buy the right security than economise and end up with a disappointingly wrong holding.
But when portfolios are managed passively – faithfully tracking a market index – then the investment process arguably becomes a commodity and price becomes paramount.
And for indexed portfolios, it is largely on price that the ferocious competition between asset managers is based – with each hoping to win a large slice of pension fund assets. Investing by tracking a benchmark is undoubtedly a growth area, with an increasing proportion of pension assets in Europe as well as in the US now managed on an indexed or passive basis.
The advantages of the ‘no-brainer’ investment method are now widely accepted – low charges for a portfolio which, if past experience is anything to go by, may perform no worse than the average actively managed one.
Even for a fund with as little as e10m under its belt, an externally managed passive portfolio could cost just 10 basis points in charges. And for larger funds with e100m behind them, the fee could drop to as low as three basis points. Very large funds may be offered a fixed fee which brings the cost even further down the scale.
With asset managers offering such low-cost management – and the apparently interchangeable nature of the product – indexed portfolios seem an obvious choice for outsourcing. But a number of pension funds have decided to run indexed portfolios in-house.
PGGM, the healthcare sector fund in the Netherlands and the second largest fund in continental Europe, runs some of its portfolios as index trackers in-house. The Shell pension fund in London, whose UK fund has assets of around £10bn (e16.8bn), runs various parts on an indexed basis in-house. The pension fund of TRW, which has taken over Lucas Varity, also does its own indexing.
So, if outsourcing is so cheap, why do these funds choose to do the work themselves?
One investment manager at a large UK corporate pension fund says that although external manager fees for passively-run portfolios appear cheap at first glance, this is not the whole story.
“You have to look at the service you get,” he says. “The 3.5 basis points in charges miraculously becomes 10 bps when you have asked for the service you need.” ‘Extras’ might include separation of your fund’s money from others, regular interaction between managers and trustees, and certain levels of reporting.
For a pension fund, the advantages of running your own indexed portfolios go beyond cost, the investment manager says. The fund can be absolutely clear what it is getting and the trustees can have more personal interaction with those managing the money. Reporting is totally separate and tailoring is no problem, he says.
In the UK, the pension fund of TRW has two indexed portfolios which it runs itself. These are a UK indexed portfolio of around £1.4bn – about 37% of the fund’s assets – and an overseas equity indexed portfolio of about £760m. The fund has never been managed externally, so when passively managed portfolios first became a part of the overall asset mix in 1995, this too was undertaken in-house.
“If you have the systems in place, it is quite mechanical,” says David Brief, managing director of TRW Investment Management. The marketing behaviour of asset managers with passive products indicates just how simple the process is, he adds.
“These days the commercial fees ... have dropped to the point where they require the development of added-value services to make a profit,” he says, citing enhanced indexing and quant tilts. “It requires good back-office systems, reasonable investment technology and some trading skills, but it is not rocket science.” A fund undertaking its own indexed investments would need to have good systems for monitoring corporate actions and good systems to monitor index changes and a good optimisation tool, such as Barra. Such tools are made available by a number of brokers, says Brief.
But there is a lower limit to the size a fund would have to be for in-house indexing to be cost-effective – perhaps £100m for a single portfolio, he says. One pensions consultant says a pension fund should have assets of at least £1bn before it could consider doing its own passive management.
Mike McShee, consultant at Buck Heissmann in Geneva, says that although some pension funds do indexing in-house, there are unlikely to be large savings to be made. “Operating a passive strategy is very much an engineering task, rather than an investment and intelligence task. All you need is a computer system – it’s almost trivially easy,” he says.
Practically, a fund has to have threshholds for making changes to the indexed portfolio. For example, if an indexed fund does not alter its holding unless a stock’s weighting within an index moves by at least 5%, then the transaction costs would be less but the likelihood that performance would deviate from the index would be higher.
But an investment manager at one pension fund, at least, disagrees. It is vital to have the right staff in-house to manage any passive portfolio. “You may think it is a job a monkey could do, but it certainly isn’t,” he says. Absolutely blind indexing would cost a lot of money in transaction costs, so most passive investors engage in some type of scaled-down version of this. This means there are judgements to be made, and this requires skill, he says.
Despite the argument that funds which manage their own passive portfolios have more control, Alvar Chambers, senior consultant at Bacon & Woodrow, sees hardly any good reasons for indexing in-house.
He acknowledges some funds have specific requirements for investing – even when the portfolio is tracking an index. For ethical or other reasons, the fund may want to exclude certain stocks. Some prefer to leave whole sectors out if they are underperforming.
But even then, external managers will quote for segregating and tailoring passive portfolios. “It will not be expensive to do so,” says Chambers. And indexing has become a more difficult job in the last few years, which makes it harder for in-house teams to cope.
There have been many major changes in indices to cope with, including cross-border shifts of large stocks. And the effect of such changes is now magnified because of the large volumes of capital globally which are now indexed, and the reactions of hedge funds as they try to take advantage of such major capital moves. “This all makes for a lot of volatility,” says Chambers.
Some funds have had their own reasons for moving their in-house indexing to an external manager. The Building Workers scheme in the Netherlands, however, has moved out of in-house indexing since the introduction of the euro. The fund, which presides over around Dfl34bn (e15.4bn), ran a portfolio based on a Dutch equities index for about two years.
“It was a Dutch portfolio and we felt that due to European integration the Dutch equities market didn’t exist anymore,” says investment director Martin Huibrechtse. The European equities market was now effectively the domestic market, but those at the fund felt it would be too complicated to run a passive fund that took in securities from across the continent. All passive management is now done externally.