Two paths to passive tactics

There are more and more ways to access passive investment strategies - in terms of fund types, approaches to benchmark replication and the range of providers. Here, Liam Kennedy looks at sampling and synthetic approaches to indexation

Active managers sometimes seem like they have a lot to prove. And right now, with loss minimisation the main priority for institutional investors’ portfolios following steep declines in all main market equity indices and poorly performing active fixed income management strategies in 2008, you could be forgiven for assuming that alpha generation is not at the front of investors’ minds.

So for pension funds looking to make the most of an equity upswing when it comes, a passive approach might seem like an attractive way to reallocate incoming contribution cashflow. This approach appears all the more attractive when one takes into account the lower fees.

Looking at the most important asset classes for our European pension fund readers - European fixed income and equity - it is clear that active managers have lost out against the index. The most recent manager data published by Mercer assess performance to the end of September and do not take the recent equity rout into account. But they show that in the European fixed income and equity universes, the median-performing manager was not able to outperform the benchmark in the majority of the six universes involved, over any of the four time frames (three months, one, three and five years respectively).

Exceptions were government bonds over three years, where the median manager recorded a 1.5% annualised performance against 1.4% performance of the Citigroup EGBI index, and Europe ex UK equity over three years and five years, where the outperformance of the median manager against the relevant MSCI and FTSE benchmarks was slightly higher, although not more than 50 bps. This still means the benchmark outperformed the median manager in 21 out of 24 data sets.

So it is unsurprising that there is increased interest in passive strategies among European institutional investors. And it seems that some funds are looking to reallocate assets. One yardstick, the public tenders of UK local authority pension funds, has shown some interest this autumn. On 7 October IPE.com reported that the £258m (€302m) Isle of Wight County Council pension fund was looking to allocate 40% of fund assets to passive strategies. This was to include UK and global equities as well as sterling bonds. In October we also reported that the £440m London Borough of Harrow was seeking to allocate approximately 25% of its to UK passive equity management.

Heavyweights have been putting their muscle behind passive strategies. Earlier this year, Paul Myners, who was then chairman of the UK Personal Accounts Delivery Authority (PADA), told the National Association of Pension Funds conference that he was going to “caution ministers to avoid adding elements which will increase the cost burden” of personal accounts. Active management, he believed, would not be of great benefit to individuals.

Says Paul Trickett, European head of investment consulting at Watson Wyatt in London: “Our perspective on passive management is that accessing market return makes sense for a lot our clients and there is a greater percentage of assets to be managed passively.” Watson Wyatt has also stressed the link between a pension fund’s governance capabilities and passive management: those with sufficient in-house resources can deploy these effectively in seeking out managers who can outperform the benchmark. Those that cannot, should make use of passive approaches.

The methods to access passive strategies are also broadening, both in the range of vehicles, approaches to replicating the underlying index and in the range of providers. And interest in passive management is spurring some traditionally active managers to offer passive approaches as a client retention tool. Payden & Rygel, the US-based fixed income specialist with end-2007 AUM of €38bn, has managed passive strategies for five years and has some $2bn in AUM, covering the Citi World Government Bond index (Citi WGBI), the JP Morgan Global Government Bond index (JPM GGBI) and the Lehman Aggregate index.

Explaining the background to the move, Robin Creswell, managing principal at Payden & Rygel in London, says his firm’s clients roughly fell into two halves this year. “There were those with whom we have long-term strategic asset holdings including bonds and over the cycle an active manager will add value on the index that we have chosen. Those clients are happy with their fixed income allocation, and happy to have active management.”

But Creswell says his firm is aware of a group of institutions that have become less certain about potential calls on their assets and more concerned about the two to three-year horizon. “What they wanted was a return very close to the index, bearing in mind that fixed income is part of a thought-out strategy, and all those carefully made plans will be thrown off kilter if they do not receive it. The calculation they made was that over the shorter term active management adds active risk and for them it made sense to go passive.”

Creswell says he was surprised at the lack of products suitable for institutions: “We thought there would be any number of funds but there weren’t that many. We could also not find any with currency-hedged share classes. And although the funds were promoted as institutional products, they clearly did not address institutional needs in terms of fees and in terms of transparency.”

This motivated a study of what was shaping up to be an interesting business proposition. Creswell says: “What we found was that other funds have quite high tracking error targets, about 20 bps, and we have a 3-4 bps tracking error target. We found their disclosed management fees were in the order of 20-25 bps and although it took some digging, we found that the total expense ratios were between 44-55 bps.”

Payden & Rygel has now launched two fund-based strategies - one modelled on the Citi WGBI and a UK Gilt fund: “For us the maximum management fee will be 15 bps and the maximum TER will be 20 bps, although for some institutions it could be be less than that.”

Payden & Rygel has opted for a sampling process for its underlying holdings. Sampling constructs an optimised portfolio using quantitative analysis to control the tracking error. A proportion of the underlying stocks are purchased, rather than 100% of them as with a traditional replication strategy. Creswell also says many UK institutions use the FTSE All Stocks Gilt index (FTSE ASGI), which has the inherent design flaw in that it rebalances every day, which adds to costs under a full replication approach.

Morgan Stanley Investment Management’s FundLogic division came into being in August 2006, but its history can be traced back to the firm’s institutional securities division. It offers a range of UCITS-compliant index mutual funds on a standardised and bespoke basis, with a special focus on institutional business, but its business spans index, hedge fund replicator, absolute return, capital guarantee and bespoke strategies.

Synthetic replication is the favoured approach for index strategies. This allows for the return of the relevant benchmark index to be reproduced using derivative instruments - such as total return swaps. It reduces the tracking error, and the approach can also serve as a source of outperformance against the index.

Anne Parthiot-Mons, managing director with responsibility for the FundLogic division, claims that tracking error can be as low as 25 or 50 bps because instead of incurring dealing and custody costs on hundreds or thousands of stocks - the biggest source of tracking error in direct replication approaches - the fund is only exposed to collateral plus the swap. Rewards for stocklending are also better, and dividend treatment can be optimised.

But what of counterparty issues in the current environment, given the repercussions from the fallout from the collapse of Lehman Brothers? UCITS III regulations limit counterparty exposure to 10% of the net asset value of the fund. Parthiot-Mons says this could be considerably less on a bespoke basis for institutions.

“We had a lot of requests from clients who were using swaps or certificates. What we see on our side is that a lot of investors who were going directly to the market are externalising this to managers like us, especially on the bespoke side, because they want someone to run their counterparty exposure,” Parthiot-Mons says. “For example, following recent volatile markets, we have a lot of funds for institutional clients where, instead of resetting on a 10% basis, we reset more frequently, and we also reset every Friday so we know we have no exposure over the weekend.”

What unites both these approaches is an acceptance that passive management is becoming an increasingly important method for accessing market returns for institutional investors, and that it can be done flexibly using a UCITS fund approach in a manner that still takes the needs of a specific group of clients into account. While the fee revenue may decline, the firm still retains a client that it may otherwise have lost. And diversity in approaches and client offerings can only serve investors well.