What is the future of indexing? How might the balance between indexing and active management develop? No firm conclusions are possible, however here are four likely scenarios.
q Divergence of indexed and active styles
q Convergence of indexed and active styles
q Indexing gridlock
q Hybrid blend

Divergence of indexed and active styles
Many active investment managers are accused of being “closet indexers”, not straying too far from the benchmark, and only diverging from the index in a limited number of ways. Similarly, many indexed managers are experimenting with tilted index funds, which seek to introduce an element of active management, by making small bets on selected stocks.
Some in the industry believe that this trend cannot continue, and that a situation needs to be found where active and passive managers diverge and become as different as possible. Pension sponsors will increasingly ‘unbundle’ current management services provided, opting to have a proportion of their funds managed in a no-frills index fund, and the remainder managed by aggressive active managers, with targets to beat benchmark returns by around 25%.
Active managers will have to become more active, and will not be allowed to get away with closet indexing.

Convergence of indexed and active styles
Other industry experts subscribe to the view that the way forward will spell convergence and not divergence of the two investment management styles. They suggest a ‘happy medium’ will be struck with active and indexed managers becoming more like each other.
Indexed managers will aim to add to their returns by offering enhanced indexed products such as tilted index funds. By the same token, active managers will aim to reduce their risk profile, and improve their performance by making their closet indexing more systematic and open.
The belief here is that almost all funds will become broadly indexed, but with enough managers taking active positions to keep the index ticking along.

Indexing gridlock
Some observers have suggested that the availability of low-cost indexing and the development of enhanced index products will result in an increased portion of the market moving towards indexing. Eventually this will lead to ‘index gridlock’, where everyone follows the market, and no one drives it. The index will be ‘locked’ on a given set of companies and prices.
This scenario seems unlikely, as it relies on a situation emerging in which almost everyone is indexing. The availability of low-cost indexing may initially lead to a greater volume of indexed funds under management. However, to seek out an advantage, this is likely to stimulate more market research, raising the incentive for investors to seek private investment information, and so increase the return on active management portfolios.
The emergence of such a dynamic balance between active and indexed management is what most industry experts. If everyone is indexing then nobody has any incentive to gather information. It would make the market far less efficient.

Hybrid blend
Perhaps the most likely scenario is that some kind of hybrid balance will be struck. Some fund managers will specialise in ‘plain vanilla’ index management, others will specialise in focused active management, and still others will offer tilted indexed funds. In such a world, performance will become closer to the index, and average fees will fall significantly, but there will be enough active management to keep the market functioning and the index moving.
No one can say how or when this might occur, but one result will be that the relationship between indexed and active managers will become less adversarial.
Some other possible future developments in relation to index management focus on the following.
q Growth in Europe In several countries, including the UK, governments are investigating the option of compulsory pension provision to supplement state and occupational pensions. It has already been suggested that index funds would be a suitably simple and low-cost vehicle for such pensions. Higher costs of active management make it uneconomic, boosting greatly the demand for index products.
q Index refinement As the proportion of indexed fund management increases, indices may need to adjust some of their rules. For example, many of the world’s leading index series have looked at rebalancing their weightings, with a view to making a free-float adjustment. Such a move would only take account of the proportion of a company’s equity that can be freely traded on the open market.
With regard to global indices and asset allocations, such re-weightings will see a more significant impact in some countries, than others. It will see companies in countries where the state retains substantial stakes – such as France, Japan and Germany – lose out in favour of the US and UK. Such index changes will have to be treated carefully.
In short, eventually it appears as though equilibrium between indexed and active management seems likely, with indexed and active funds increasingly seen as complementary. Also, within Europe in particular, indexed funds will increase their role in personal pension provision as welfare systems are reformed.
Chris Sutton is head of passive investment strategy at Barclays Global Investors in London