By Julian Harding
Index investing is available across equities, fixed income and an ever-wider range of alternative asset classes, providing powerful, cost-effective ingredients to build diversified investment solutions for DC members.
Index building blocks give members broad access to the growth opportunities or defensive attributes that each asset class offers individually, as well as providing the market-risk mitigation that more complete asset diversification can bring. And, with costs contained, more sophisticated portfolio management techniques can be added, such as tools to help control overall portfolio volatility.
Indexing is rightly seen as a straightforward and transparent solution for investors but getting the underlying indexing right — tight tracking of the benchmark — is not so easy. An index manager’s job is to deliver benchmark returns year in and year out — a task rather more nuanced and sophisticated than one might expect. The range of tools, techniques and manager insight needed to deliver precision and value demands the deep experience and institutional capacity of global index managers.
A benchmark assumes that the world is frictionless and that index changes (when a company is added/deleted from the index) and corporate actions (when a company makes a change to its stock) are instantly reflected free of charge. In reality, investment managers need to take into account intricacies such as trading costs, taxation and market liquidity, and they might encounter some benchmark rules that can’t readily be replicated in a cost-efficient manner. Accounting for these requires a vast range of individual decisions to be made and executed correctly in order to deliver consistently low tracking error and a better risk profile.
Stronger index managers can also deliver additional value through techniques such as effective index-change trading strategies, corporate action selection strategies, crossing of securities trading (the mix of buys/sells of a stock can be offset against each other for little or no cost), stock-lending arrangements and precision trading. These strategies can augment performance and tracking in a risk-controlled way, providing a valuable uplift that ultimately can assist the scheme in meeting its return targets.
Accessing the transparency and value benefits of indexing is no longer contained to market cap-weighted benchmarks. Smart beta strategies have evolved to provide even greater choice for DC schemes looking to move the dial on cost-efficient, risk-adjusted returns in their portfolio. Indexes target market factors like value, size, low volatility, quality and momentum. They offer the opportunity to achieve the specific returns of these factors, which were previously the domain of expensive active investment strategies, while at the same time retaining most of the benefits of traditional indexing. For clients focused on improving their overall portfolio — the returns over time, lowering risk or a combination of the two — these indices can be viable choices.
Elsewhere, increased awareness of environmental, social and governance (ESG) concerns introduces new opportunities for investors to rethink traditional investments. ESG indexing is increasingly becoming a vital component for many investors; as well as generating returns over the long term, it’s generally thought to have risk mitigation benefits in a portfolio.
What are the key ways an index manager can add value?
The right index-change trading and corporate action selection strategies are key, but turnover reduction strategies are also critical. By carefully analysing each change, it may be incremental value can be added and the index tracking capability of the fund can be maintained, while also not necessarily trading some of the smaller changes. This means less trading and so gives rise to lower transaction costs — every pound saved is another pound that stays in the client portfolio. Other value-added activities, such as risk-controlled stock-lending and crossing of securities trading, can also be used to further improve risk-adjusted returns.
How should trustees and scheme sponsors evaluate their index manager?
Each client will have their own criteria and priorities but we believe that some requirements are universal. Indexing is a complex business, so look for managers with long institutional memory and index fund management teams that are established, with a significant number of senior portfolio management personnel with long tenure. Trustees and sponsors should also ensure that the fund range they are offered is broad and relevant, with tailored or bespoke solutions available where required. The nature of indexing is such that it benefits from extensive resources and depth of index fund management. How many equity and fixed income portfolio managers and traders do they have globally? And what support units do those managers have? Finally, strong risk compliance and corporate governance cultures are a must.
Julian Harding is managing director, global head of core beta research at State Street Global Advisors
