The boom in index-based fund management has not removed the need to customize portfolios in efforts to achieve desired risk/return exposure profiles.
In recent years the number of indices has grown to reflect the increasingly diverse nature of investment markets, and index fund managers have witnessed large asset inflows as investors have embraced these strategies. This evolution, however, has not completely addressed concerns among some institutional investors regarding the composition of the benchmarks.
One factor fueling the demand for index products in both equity and fixed income is a school of thought that holds there are fewer opportunities for active investment managers to outperform market indices, particularly in developed markets. Not surprisingly, active managers argue that markets are inefficient and they have the skill to outperform the representative benchmark. But what if the inefficiency has less to do with the underlying market and more to do with the inefficiency of the index itself?
By design, indices are based on rules defined by providers to capture the overall market return, known as market beta. As a result, managing against an index can cause exposures to securities, sectors or countries that may not be aligned with an investor’s investment objectives. Investors and portfolio managers often have cited challenges with equity index weights driven by market capitalization. Similar concerns have been expressed about fixed-income index country weights determined by security issuance. In both instances, the weightings do not account for desired risk parameters. Fundamentally weighted indices and other weighting schemes — such as equal weighted or weightings based on gross domestic product (GDP) — have attracted much attention and have addressed some concerns.
“For a number of years there has been debate within the industry around index construction methodology and the market exposure gained through traditional indices. A number of market participants have highlighted the need for a more effective approach.”
—John Krieg, managing director, Europe, Middle East and Africa, Northern Trust
“For a number of years there has been debate within the industry around index construction methodology and the market exposure gained through traditional indices. A number of market participants have highlighted the need for a more effective approach,” says John Krieg, managing director, Europe, Middle East and Africa at Northern Trust, London. “This has led investors to ask if there was a better way.”
What are the implications for investors? Currently investors spend a high proportion of their time on asset allocation, deciding whether to choose active or index managers, then selecting investment managers and finally monitoring the chosen managers. Relatively little time is spent on analyzing the index itself, the market beta of asset allocation decisions. Investors are beginning to question the very basis of traditional index construction as they look to achieve their distinct risk/return goals.
David Rothon, fixed-income investment strategist at Northern Trust, London, comments, “Investors are familiar with customizing investment guidelines to meet exacting requirements, but often use an ‘off the peg’ index when they could have a customized index.”
Although both active and passive strategies have a role in portfolio construction, closer collaboration between both disciplines is needed to achieve investor objectives. It is no longer a foregone conclusion that alpha (outperformance) is the result of market beta plus the active manager’s skill, as perceived alpha could derive from inefficiencies built into the benchmark.
This has given rise to a new approach where the active and index management worlds merge. In an actively designed, passively managed investment strategy, minor modifications to conventional index strategies or more sophisticated weightings are utilized. The actively designed, passively managed approach focuses firstly on understanding index exposures, then secondly on the design and modification of the index for exposures you want. The final step is implementation, which is done in the same way as mainstream index strategies.
“Issuers with the largest amount of debt tend to hold higher weights in the index, and it’s often the case the very same issuers have a lower-rated credit quality as a direct result of servicing this level of debt.”
—David Rothon, fixed-income investment strategist, Northern Trust
“What is the outcome of actively designing an index for desired exposure and then passively managing the portfolio? Although this investment strategy remains relatively new, investors using this approach can benefit from the risk-efficient and cost-effective nature of index management while achieving the desired market exposure to meet specific investment objectives,” Krieg explains.
To understand the flexibility of an actively designed, passively managed strategy, it is often necessary to see how in certain circumstances traditional indexing can leave investors with unintended exposures. For example, fixed-income indices are constructed on the basis of the outstanding amount of bonds, which defines their weighting in the index. This leads to the possibility of an investor gaining undesired over- or underexposure to a particular country, sector or issuer.
“Issuers with the largest amount of debt tend to hold higher weights in the index, and it’s often the case the very same issuers have a lower-rated credit quality as a direct result of servicing this level of debt. For example, Spanish and Italian government bonds represent nearly 35% the Barclays Euro Treasury Index,” explains Rothon.
“The choice for investors is rather straightforward,” Krieg says. “Do you want to have the exposure that has been predefined by whomever, by whatever rules they have put in place, or do you want to be a little more customized, working with your investment manager to meet your objective?”
The active design component of these strategies can be quite simple and can be based on any number of factors, such as screening out securities an investor does not wish to hold or GDP models.
The starting point would be the existing traditional index, followed by a consultative discussion of the risk factors and exposures the investor wants to screen out or modify. Within fixed income, this discussion could begin with duration and credit quality bias, then move to custom weightings, equal weights, country exclusions, future issuance patterns, home country bias, liquidity and macro views. All of these factors can be incorporated into the index.
In one example, a large European corporate pension fund required exposure to Euro Inflation-Linked bonds, but had concerns, later validated, about the risks presented by the periphery of the Eurozone, countries such as Italy and Greece. Rather than buying a broad market Euro Inflation-Linked bond index, the pension fund opted for a custom index focused on the most credit worthy economies, primarily Germany and France. Since the fund’s objective was to hedge against inflation risk in the European Union, the index was structured to resemble the duration and certain characteristics of the standard index, but without the two undesired issuers. As a result of the active benchmark design, the portfolio out-performed the broad market index â€” a result which was heightened during the European sovereign debt crisis.
“Some investors are considering even more complex passively managed strategies and moving further into areas that traditionally would be the purview of active, quantitative managers.”
—Brad Adams, senior product manager, Northern Trust
“Some investors are considering even more complex passively managed strategies and moving further into areas that traditionally would be the purview of active, quantitative managers,” adds Brad Adams, senior product manager at Northern Trust, Chicago.
He notes one investor wanted a long-duration, liability-based bond portfolio. “The decision was made to select an investment manager adept at managing against the component pieces of a customized benchmark that was designed to match the investor’s liability stream,” Adams explains. “The investment manager focuses on managing the portfolio by its component pieces passively, rather than an active approach that would have involved coordinating the full portfolio.”
The customized index comprises four components. The first consists of bonds from a specific list of highly liquid U.S. Treasury stripped securities that reset once a year to match changes in the investor’s liability stream. This component was created in a near-replication strategy and is passively managed until it must be reset to mirror the benchmark.
The securities within this component provide the duration needed by the client for the whole portfolio. The remainder of the portfolio is composed of mortgage-backed securities, U.S. credits sector securities, and Treasury Inflation-Protected Securities. Each of these components is passively managed with regular rebalancing to stay in tune with changes to the corresponding sector index. The investment manager’s primary responsibility is then to manage the three sub-portfolios against their respective indices, none of which are individually long-duration or liability-based.
“With the proper balancing, the four components end up matching the benchmark characteristics and the liability stream through a passive strategy,” Adams says.
There is no outperformance objective to actively designed, passively managed strategies, Krieg concludes. “Beta is just market exposure and it’s being achieved in a customized way. It all comes back to defining what risk/return exposure investors want, designing a custom benchmark to match it, and managing passively against that.”