The main marketing problem faced by index-tracking investment managers is the difficulty of differentiating themselves from the competition.
Understandably, index-tracking investment management is often regarded as a commodity product and, like most of these products, it is price that matters. For index-trackers, the price is specifically the ongoing management charge and, in many cases, the costs of the initial transfer of assets to the index-tracking funds.
I will leave aside any discussion on the differences between passive management and index-tracking management (the latter being a subset of the former) as this is less about which manager to select than deciding on the investment management mandate itself. If you decide that indices are bad benchmarks, it is best to do so before you start thinking about which manager to select. I will focus on traditional, middle of the road index-tracking products benchmarked against established indices
Firstly, we need to satisfy ourselves that an index-tracking manager can track an index effectively. Constructing index portfolios is perhaps less straightforward than imagined, but it is nonetheless well within the capacity of most established investment houses. We still need to be satisfied that the index-tracking team is effectively resourced and that its pooled investment funds are properly established. Since index-tracking management benefits from economies of scale, very small operations are at a disadvantage.
Administration quality is a further consideration as poor admin is more apparent at an index-tracking manager than at an active manager because there is no prospect of outperformance to dull the pain. However, aside from these areas, a prime consideration when selecting an index-tracking manager is the subtle differences in approach between managers whose general ability to track an index is not in doubt.
In recent years, a few investment managers who previously described themselves as traditional, middle of the road index-trackers have now introduced the prefix ‘enhanced’ into their presentations, and even their marketing literature. In practice, they are not necessarily doing things any differently, but the use of the word enhanced does highlight an area of differentiation between index-tracking managers. The objectives they set themselves often go beyond simple ‘slavish’ tracking of the index. Most will also aim to minimise client costs, although in many cases the latter objective conflicts with the former.
There are two broad areas in which the conflict arises. The first is transaction costs – the costs involved in trading stock in the market. Indices do not allow for them, but they are a fact of life. The more an index-tracking manager trades, the more costs will be incurred and the larger and more negative the ‘tracking’ will be. The term tracking here simply refers to the arithmetic difference between the manager’s return and that of the index.
To reduce the need for trading, the index-tracking manager must be prepared to accept, at least some of the time, greater differences between its portfolio and the index than it would otherwise like to see. In other words, it must accept larger stock positions (the differences between the weightings of stocks within the portfolio and the weights of those same stocks in the index). The larger the stock positions, in general terms, the larger the potential tracking.
There is consequently a balance to be struck: how much uncertainty in the tracking can be accepted to reduce expected trading costs? Different index-managers come to varying conclusions about this and, as a result, construct their portfolios differently.
The limiting case is the index-tracking manager who adopts what is known as a ‘fully replicated portfolio’ in which all stocks are held as close as possible to their weights in the index at all times. Other managers adopt a more pragmatic approach to replication by holding all, or nearly all, the stocks in the index, but permitting narrow ranges of tolerance for stock positions relative to the index.
Then there are those managers who make no attempt to replicate the index in any form (even where the volume of assets would permit such an approach). Instead they build some form of optimised portfolio designed to closely mimic the characteristics of the index, while at the same time, for example, minimising exposure to the most illiquid stocks that cost the most to trade. These differences in approach have various implications for clients in terms of potential tracking and can therefore be considered as differentiating factors.
The second area in which cost conflicts with low tracking is in the willingness of the manager to take opportunities to add value. There are a number of sources of potential added value to the index-manager, but the two most prominent, in the UK at least, are the management of index constituent changes and the use of stock lending.
Index constituent changes are, as their name suggests, changes to the list of stocks included in an index and/or changes to the weightings of those stocks. Such changes can arise as a result of corporate actions (mergers and takeovers, demutualisations, initial public offerings (IPOs) etc. or as a result of an index constructor changing its rules (the free float changes to FTSE and MSCI indices this year and next).
The changes in index constituent changes have tended to be regarded as a source of added value because there is reasonably strong evidence that the prices of affected stocks are distorted at or near the point of change. Stocks joining an index or whose weights are increasing have had their prices temporarily inflated, whilst those leaving have seen them depressed.
The low risk approach to constituent changes for the index tracking manager is to reorganise its portfolio at the same point that the index change takes place. In other words, to trade at the distorted price. Tracking will be fine, but the client may have got a bad deal. It may have paid too much for its purchases and received too little for its sales.
Consequently, most index-tracking managers will choose to take a little risk with their tracking by changing their portfolios either before or after the official index change date. In this way, they would hope to avoid some of the price distortion and obtain their purchases at a lower price whilst receiving more for their sales.
There is, however, a clear risk here. There is no guarantee that the prices of stocks affected by index changes will be distorted. Unless there is a general bias towards prices being too high for new index entrants and too low for exits, an index-tracking manager who doesn’t change its portfolio with the index is doing no more than taking unrewarded risk.
While price distortions have been evident in the past, they may not continue in the future. There is therefore another judgement to be made by the index-tracker in deciding how much it will be prepared to move away from the index at the point of change. Once again, index-trackers will draw varying conclusions and this is another area of distinction.
Stock lending is something index-tracking managers have been doing for some time. Although the mechanics will not be elaborated upon here, suffice is to say that it involves, ‘lending’ stock from an index portfolio to a third party. The ‘loan’ is covered with collateral and is marked to market (that is, adjusted according to moves in the market value of the stock). The index-tracker receives a small premium for providing the service, some or all of which is passed onto its clients. Risk is low, but not non-existent. Most index-tracking is now through pooled funds, so an investor must accept stock lending within the pooled fund if the manager does it or else find another manager. Some index-trackers lend stock better than others and this needs to be considered in the selection decision.
Overall, the distinctions between index-tracking managers are rather fine, which is as it should be. Investors choose index-trackers because they minimise what may be termed the selection risk involved in selecting an investment manager. Unfortunately, this also means that competitive pricing is crucial, like it or not.
Steve Woodcock is a senior consultant at William M Mercer in London
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