John Krieg discusses the findings of a survey of institutional investors' changing perspectives on passive investing, and the growing use of customised beta strategies

The turbulence and uncertainty that has confronted investors over the past 10 years has given rise to an increased focus on transparency and risk management. At the same time, many investors are now focused on meeting objectives for their portfolios that go beyond simply outperforming a benchmark.

In response, a new range of passive strategies has emerged, moving away from traditional/cap-weighted indexing to alternative indices and, increasingly, customised index approaches.

To examine the evolving use of passive investments in institutional portfolios, Northern Trust engaged Greenwich Associates to interview 121 institutional investors, 41 of which were in Europe. In particular, we examined investors' expectations for using passive management in the future, the effect of increasing passive use on investment decision-making, and concerns about benchmark construction methodology.

Whereas historically most institutions defined the overall goal of their investment portfolios as outperforming a benchmark, today the primary task is meeting the overall objectives for the investment fund - 84% say this is more important. One investor summarised the view of many European respondents, stating that "[the overall goal of our investment portfolio] is staying fully funded, and having a cushion to take care of volatility."

As a result, passive investment products that deliver market performance at a relatively low cost are increasingly important tools. Approximately one-third of respondents say passive products make up more than 40% their assets, and a sizeable number expect to increase allocations. Approximately four out of 10 expect them to make up more than 40% of assets by 2014.

European institutions are much more likely to report relatively large allocations to passive products. Approximately 45% of institutions in Europe report that passive funds represent more than 40% of equity and fixed income assets, and approximately 57% expect to cross that threshold in the next three years.

As institutions ramp up their use of passive strategies, they have begun to examine benchmark construction - and 37% describe themselves as "concerned" or "very concerned" that the standard construction of cap-weighted indices may affect achieving their goals.

Globally, 63% of participating institutions say that known benchmark inefficiencies should be addressed and removed, a figure that jumps to 78% in Europe. Specifically, they noted the bias towards larger market capitalisation in equity indices. For fixed income, their concerns centred on biases toward larger debt issuance.

As one European respondent put it: "It is becoming a big issue. So far we haven't looked at indices very closely, but many banks are now offering indices which are for your own portfolio, and that is what we are looking at very shortly."

At a global level, the four most important factors that drive benchmark selection are market-cap coverage; style biases; weighting methodology; and sector/country biases. North American institutions rely primarily on the first three criteria when selecting a benchmark.

In contrast, institutions in Asia and Europe regularly consider a much broader range of factors, including benchmark currency, number of securities, rebalancing policies and index rules.

In practice, a common objective that we often encounter is to achieve emerging markets exposure. Many passive portfolios based on cap-weighted global equity indices can fall short of the level of exposure institutions might prefer for smaller emerging markets.
In seeking alternatives, the first step is typically towards an equally-weighted index. Investors that want to take things further might use benchmarks tactically or for theme-based investing to include regional or sector exposure.

Investors requiring a more specific approach might consider a fundamental or GDP-weighted index, and they need to understand the potential investment implications as they evaluate the roles these strategies might play. If these are not meeting their needs because of their limited transparency, high turnover or limited breadth of coverage, some investors may tweak an existing index or design their own.

A variety of terms have been coined to describe these efforts, which can be viewed as sitting in the exclusions, tailored indices or engineered beta buckets on a spectrum of beta, including smart beta, intelligent beta, engineered beta and others. We refer to these as customised beta.

Almost half of European institutions say they would use customised beta if the tools were readily available. Institutions see two primary benefits: improved risk/return trade-offs and increased diversification. Asian institutions see customised beta as a possible tool for eliminating inefficiencies within their portfolios.

European institutions see customised beta strategies as having the potential to boost transparency within their passive portfolios. They also are among the world's most enthusiastic proponents of environmental, social and governance (ESG) investment practices, which can be challenging when using traditional cap-weighted indices given that needs differ from investor to investor. Customised beta approaches can provide an efficient screening tool for institutions looking to comply with these standards.

However, only 22% of respondents have conducted analyses of the implications of these approaches. This finding reflects the fact that institutions in general spend the majority of their time and resources on active management - in particular, on the task of selecting managers.

Globally, 41% of respondents spend more than 30% of their time on manager selection (see figure). In contrast, for about 62% of the respondents, benchmark selection occupies 10% or less of the time they devote to investment activities. Interestingly, 7% of European institutions focus over 30% of their time on benchmark selection versus 2% in North America and 0% in Asia.

Investors do face challenges when considering non-traditional indices for a passive investment. One European institution observed that customised beta is "relatively new and doesn't have a proven track record".

Another pointed to trustee regret risk: "Inevitably, there will be some periods of underperformance and people would start getting worried. We would get board resistance."

However, given the attractiveness of passive investing's fundamental tenets, we anticipate that further adoption of these newer approaches will occur fairly quickly. Indeed, many are moving towards a customised beta approach without even recognising it.

"As the market evolves, what we once considered to be part of our alpha-generating portfolio five years ago we now consider part of our passive portfolio," explains one investor.

In the past 10 years indices have been launched that offer both style beta (value weighted) and strategy beta, essentially shifting the line between alpha and beta and perhaps explaining why 41% of European respondents do not consider alpha-beta separation very relevant to their portfolios - a position not witnessed in North American or Asian-domiciled respondents.

Northern Trust believes the introduction of a broader array of beta solutions is a positive development, providing investors with opportunities to refine alignment with their investment goals.

The market today remains segmented, with some investors gravitating towards traditional index solutions while others are exploring the possibilities of custom indices.
The spectrum of beta to alpha solutions has never been better, providing an excellent opportunity to review your investment goals with your asset managers and consultants, and to explore implementation opportunities suitable for your investment purpose.

John Krieg is managing director, asset management, EMEA at Northern Trust