Passive management has had its fair share of knockers in the last few months.
Consider the recent assertion by Paul Woolley, chairman of fund manager GMO Woolley, that passive investment may be popular, but that it is undermining equity returns and promoting market bubbles and implosions. Woolley argued that by going passive, investors were abdicating their market power in favour of corporate issuers. In turn, the dominance of tight tracking strategies in the UK and overseas was resulting in the mispricing of securities and misallocation of capital.
A similar warning to investors emanated recently from Standard & Poor’s who reported that tracker funds were often seen as attractive by investors looking for the cheapest, easiest and lowest risk investment option, but that investors using indexation strategies in order to avoid sector or stock-specific risk could in fact be doing the reverse.
While both are valid discussion points, it is business as usual for index tracking, which has for many years borne the brunt of Jeckyl and Hyde treatment: the money continues to pour in from institutions, while the spectres of market distortion and saturation are held up as a warning by commentators that it could all go so so wrong…
Despite the plunging markets of the last two years though, indexation has shown an immunity to both the critics and the markets – bucking the received wisdom that bear markets benefit active managers.
While active managers appear on the whole to have failed to satisfy investors, indexation marches on – even blurring the boundaries between active and passive managers through fledgling products such as enhanced indexation. A recent joint report by Oliver, Wyman and Company and UBS Warburg, entitled: ‘The Future of Asset Management’, found that continental European institutional investors currently manage only around 3% of their equity allocation on a passive basis, compared with 20% in the UK and 30% in the US.
Interestingly though, the report predicted that European levels would gradually converge towards Anglo-Saxon levels.
The report argued that one reason for the predicted shift is that continental pension fund boards/trustees have seriously begun to question active manager performance. The bear market has left many wondering whether the fees paid are justified when returns have proved to be less than impressive. Furthermore, the influence of state-funded pension schemes choosing large passive allocations and the creation of investor-friendly indices are helping to boost the cause of passive management.
Certainly in those markets where passive management has taken sizeable chunks of institutional money, there is little sign yet of scaling back – even in the UK, where indexed funds now account for an estimated 30% of the equity market, while another 30-40% is thought to be closet-indexed.
The £1bn (E1.6bn) Aberdeen City Council pension fund has a sizeable £250m passive investment portfolio. Joanne Hope, superannuation fund officer, explains that for the moment it is a case of sitting tight: “We are just in the process of having an actuarial valuation done and off the back of that we will be having an asset/liability study, so we are comfortable with the position we are in now and do not want to make any changes until we can get some flesh on the bones of where we should be going. We don’t know what that direction will be at the moment.”
Hope says she sees no evidence in the UK market of pension funds changing their approach to indexation: “We’ve definitely had added value from our active managers over the last 12 months, but by the same dint our index manager has done what they were employed to do.
“In general, I think everyone is considering what the market is doing rather than how to deal with the market. People are not adding much value through active management, they’re just waiting to see how far the market will drop.”
Hope adds that enhanced indexation is also something the fund will consider as part of the forthcoming review: “At the moment, it doesn’t have much of a track record, but that does not mean there is no potential there and we recognise that it is something we have to take into consideration.”
In some European markets, however, overt dissatisfaction with the performance of active managers is driving the passive story forward.
Sverker Lindstrom, managing director of consultant, Lindstrom & Partners, says Swedish institutions have been extremely disappointed with the performance of active managers in Sweden and as a result have started to think in terms of indexation.
“The Swedish market is performing really badly because we have too many IT/Technology stocks in the index. Quite a number of our pension funds have lost around half of their capital and if you combine that with poor manager performance it is a mess! Therefore, Swedish pension funds are seeking to find other solutions for their assets – either going into fixed income and leaving the equity market, or going into the guaranteed /passive market.”
Significantly, Lindstrom points out that the providers in the passive arena are not Swedish banks, suggesting that if the trend intensifies it could have lasting effects on the make up of the Swedish asset management market. “The issue is that many Swedish managers need to hang on to their active fees to survive!”
In other markets the passive trend is part of a wider strategic shift. Sven Ebeling, senior consultant at Ecofin in Switzerland, says there has been a notable move towards indexation in Switzerland due to the development of the core/satellite approach within the risk budgeting framework that most Swiss funds employ.
“Both issues would support the idea of establishing indexed portfolios from a theoretical point of view, and we are actually seeing that in the market also.”
However, he notes that the recent market swings have made the consultant hesitant in recommending passive strategies to clients. “If you index you fall with the market and at the moment people are trying to find some way of protection against these falls. However, it is unclear whether active management can deliver that protection or whether there should be a move away from the more traditional active/passive approaches to look at hedge fund strategies, etc.”
Ebeling believes that most Swiss pension funds, however, are still in the ‘appetiser’ stage regarding exposure to alternative assets, thus slowing up any such strategy shifts.
“In fact, at the moment we are in a bit of a difficult situation. Indexation seems to be generally accepted, but people are very reluctant to commit given the current market conditions.”
In terms of enhanced indexation products, Ebeling says the firm has recently established some portfolios for clients that could be labelled as enhanced, although he notes that the trend is by no means widespread in Switzerland.
One fund that has taken on the baton of enhanced indexation is the Dutch e12bn PMI metalworkers fund.
Roland van den Brink, managing director at PMI believes that in efficient markets it is hard to find an active manager that will add value to pension fund investments.
In 2001, the fund carried out a detailed review of its investments before making major allocations to the tune of e1.4bn to passive management – with the focus clearly on enhanced indexation strategies. “You can go for pure indexing or indexing plus.
“I’m not saying that pure indexing is an old style approach, but the indices themselves are not efficient – I’m thinking of the cases of Unilever and Shell in the S&P500.
“A more modern way of indexing is to go for enhanced – it gives the best of both worlds, all the computer power and calculation of the efficiencies in the market and secondly a low risk profile with potential for excess returns,” says the manager.
Van den Brink believes the fund was fortunate to have gone down the enhanced indexing route just as it was maturing. “In the last few years, some participants have come forward with products even though the concept was still in development. We saw that these participants could deliver very good results and this has been the case.”
The PMI fund has portfolios with both State Street (e1bn) and Merrill Lynch (e400m) and van den Brink claims both have performed well, despite employing very different enhanced approaches.
And the PMI manager notes an incongruity that may mark the development of enhanced indexation in Europe: “If you talk to an American they say it is active management. If you talk to a European they say it is clever passive management if it is up to a tracking error of 1%. That’s a big difference, that Europeans are still perceiving it like this.
“The attitude in Europe is that indexing is great but pension funds won’t pay for it as a fixed fee – you should earn your money as a performance fee, which is fair in fact.”
Although declining to comment on the fee for enhanced indexation, van den Brink notes cryptically that at the time the fund placed its e1bn with State Street it was the firm’s largest client for the product.
If anything then, the passive/active equation has become the new variation on the traditional active/balanced saga for institutions across Europe. The underlying message coming out of Europe’s pension funds is that this will take the form of some kind of core/satellite decision, with each market no doubt developing its own idiosyncrasies. Gradations of indexed investment will remain, however, very firmly in the centre.
Passive may have its knockers, but its ability to absorb the blows is testament to the fact that its success is linked to a wholesale transformation in the way that pension funds across the whole of Europe are beginning to invest for the future.