Essentially, enhanced indexing breaks down into two categories. First are those funds where the enhancement is a slight rebalancing of the index based on technical issues rather than picking stocks, incurring perhaps just 50 basis points of active risk. The manager might for instance move quickly to buy a stock that is joining the index. These remain a popular option.
The enhanced tracker style funds that largely bombed last year, however, were the funds where the manager moves away from the benchmark and builds a different portfolio, based on fundamental analysis or quant, taking around 2 per cent active risk – more than plain tracking, but not the 4-5 per cent risk of an active manager.
“The critical issue last year is that a lot of enhanced index funds didn’t deliver the little outperformance above the benchmark they were marketed to,” says Daniel Peters, investment consultant, Aon Consulting. “Markets in 2007 weren’t rational. Of the two models, the problem was forced selling in the quant, which produced returns outside where investors would have expected enhanced indexing to be. There’s that old saying: ‘Quant works well until it doesn’t’.”
“Prominent indexing names have been hit hardest,” says Joel Dickson, head of active quant group at Vanguard. Vanguard’s own S&P 500 fund fell 48 basis points against the index but even that did relatively well compared with its peers. At 15-25 basis points a year, enhanced indexing costs only marginally more than the 5-6 basis points per year for vanilla indexing, which theoretically should be worthwhile but not of course if the manager ends up south of the index.
“One of the main drivers was not so much the August event that received so much press as much as the entire second half of 2007,” explains Mr Dickson. “The value component of the quant system failed in a way not seen since 1999. Quant models generally comprise three areas – valuation (which has been hardest hit) and momentum, and corporate health, such as the strength of the balance sheet and insider dealings, which did not perform so poorly.”
“Not only did enhanced indexing funds get into trouble in the second half of 2007, but many managers oversold their potential,” adds Mr Dickson. “Late adopters will have been disappointed, and may switch to vanilla indexing. Those who have used enhanced indexing for a number of years will not be happy and will have questioned what is going on, but I think they are less likely to move.”
Funds of hedge funds, however, are already cutting back on quant funds - and as a group able to move fast - this could be an important indicator of future trends.
Some of the biggest indexers, such as Barclays Global Investors (BGI) and State Street, were most disappointing. “The important thing about enhanced indexing is that it is risk-taking, although the risk may be lower,” says Nico Marais, head of active equities at BGI.
Mr Marais argues there is a growing distinction in the quant space between a homogenous group of old style quant managers, who ‘rely on historical patterns’, and a few ‘truly scientific’ managers.
“Ideas lose value over time so you need to be more proprietary and innovative,” says Mr Marais. “The issue is: Does the manager have access to proprietary data or are they using the historical data everyone else is using? Do they have an insight into every company globally? There is no way a small group can look at every single company and use ideas across the globe. Many managers only research winning companies, for example, and lack the wider perspective.”
“Many of the smaller outfits that rely on sell-side ideas and historical patterns are finding times hard and they’re becoming generic because what they do is what everyone else is doing,” adds Mr Marais. “Scientific managers don’t start with historical trends but with new investment ideas and then use quant methods to implement them. We expect continued growth for scientific managers but believe that investors will question the more basic, generic version.”
“If you really get down to it, most quant models are betting that historical experience will repeat itself,” says Mr Dickson. “The problem with driving by a rear-view mirror is that sooner or later you will run into the wall in front of you.” Generally, however, that hasn’t been a bad strategy, he adds.
Out with the old
Mr Dickson has concerns that managers are now adjusting their models on the basis of this nine-month period of underperformance, when they might usefully be investing more in their risk control frameworks. “There’s a risk in tweaking the models if that takes you away from simplicity and economic theory. I worry that instead of tightening some bolts they are throwing out the old engine and replacing it with a new one,” he says.
“Enhanced indexed managers will also respond to their awful 2007 by saying they want more freedom,” adds Mr Peters. “The question for trustees is why they should have more freedom when they’ve failed to prove themselves with only a little freedom. Trustees should need to be even more convinced that they’re good.”
One exceptional performer last year was Henderson, whose Global Enhanced Composite Index fund has returned 70-75 basis points over one, two and three years to the end of 2007, with an information ratio of over 2 per cent. The manager’s multi-strategy equity indexing operation involves four different engines – fundamental, liquidity, event-driven, and relative value - which tend to work better at different times and together aim to provide a smoother blend through the economic cycles.
Active fees offputting
“Clients who have been with active managers and are disappointed, especially with the active manager’s fees, are switching,” says Alistair Sayer, investment director at Henderson. “This constitutes the bulk of our conversations with consultants.”
Meanwhile in the active space many managers are closet indexers, something the industry has been grappling with for decades, but which is hard to deal with so long as performance is measured in traditional ways.
“You either have to believe that it is possible to identify opportunities and thereby generate alpha, or that it is not,” says Richard Warne, head of UK institutional business development at Morley. “There has been a very marked trend towards separating out beta and alpha even prior to the recent volatility.”
“Investors are now either looking to have a strategy focused on beta to reduce their costs, on the assumption that few managers can outperform the indices, and on the other side to managers that can generate good returns even in difficult times, where they are looking for businesses with the right people, culture and processes.”
Mr Warne cites Morley’s PP UK Equity Focus Fund as an example of a fund where the alpha added by manager, in this case David Liss, has consistently beaten the market, returning 9 per cent, 17.7 per cent and 18.6 per cent over 1, 3 and 5 years net of fees respectively.
“The more mature the market, the more investors will refuse to pay additional fees to invest in managers who are essentially closet-indexers,” he adds.
In the efficient US market, active fund managers stand to lose approximately $12bn a year in potential management fees, according to research by TABB Group. Performance Anxiety: A Buy-Side Study of Benchmarks and the Investment Process written by TABB research director Adam Sussman, argues that the trend stems from the transformation of investment performance measurement so that instead of comparing a manager's returns against a broad market index or similar funds, investors are using more precisely tailored benchmarks. Index-based assets under management have grown by 2,610 per cent since 1993, says Mr Sussman, there are now 48,256 possible indices, which is more than the 40,365 publicly-traded companies.
Mr Sussman estimates that by 2009 nearly 70 per cent of pension plans representing $40,000bn (€25,000bn) AUM will be using customised benchmarks, to measure more sophisticated portfolio structures with an emphasis on cheap indexing for the core and more complicated alpha generating satellites perhaps involving alternative assets or derivatives.
“There is a bigger case for enhanced indexing in markets such as the US and Japan which are difficult for the active manager to add value in,” says Andrew Wilson, head of investments at Towry Law. “In current opaque (developed) markets it is difficult for the active manager to look beyond the end of his nose, so it may not be worth paying active fees a until the market calms down and you might just as well take beta this way.”
In global markets, however, active management outperforms the indices, due to the inefficiency of emerging markets, by around 2-3 per cent, says Lucy MacDonald, CIO Global Equities for RCM. “Over time it will become more difficult to outperform the median but until all money is managed globally these anomalies will remain.”
Arguably, quant has advantages over active management in its risk control framework. “Active managers have big egos and can expose their clients to even greater volatility and think their stock-picking will always be successful but even if it is very good, their stock picks will only outperform 50-60 per cent of the time,” says Mr Dickson.
Index composition
Traditional active managers take lots of unintended bets in style as they are benchmarked to a market cap weighted index, but interest in alternative indexing methodology is gathering pace. The term ‘beta primes’ is applied to strategies based on four styles of index composition – equal weights, factor tilts, fundamental weights, and risk tilts, which all capture a premium from market volatility due to mispricing. Fundamentally-weighted indices may offer a better way of harvesting a value premium, for example, while the constituents of risk weighted portfolios should be less closely correlated in difficult markets.
“We have not done a lot of enhanced indexation in the past especially in UK & Europe, preferring instead to use benchmark insensitive managers or passive managers,” says a spokesman for Watson Wyatt. “The most interesting development is beta primes, where we see significant potential.”
