Changing Perspectives on Passive Investing

Turbulence, uncertainty and inconsistent returns epitomized the past 10 years of investing, leading some institutional investors to reconsider their objectives. Risk during this period was not necessarily rewarded, placing new focus on transparency and risk management. This, in turn, sparked a shift toward passive investment strategies.

Research conducted by Northern Trust in conjunction with Greenwich Associates highlights how the increasing use of passive investing is leading to a blurring of traditionally held views on the separation of alpha and beta. The survey of 121 institutional investors around the globe also reveals more choice for investors within the spectrum of beta and the increasing appeal of customized indexes.

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Investing with Purpose

Institutions today see their primary task as meeting the overall objectives for the investment fund. While specific objectives vary based on an institution’s priorities – such as maintaining funding status, hitting return goals within a risk budget or maintaining downside protection – there is little doubt that organizational requirements have replaced relative performance as institutions’ primary measure of success.

Of the institutions participating in the Northern Trust study, 84% globally say that meeting their own unique investment objectives is more important to them than outperforming their chosen benchmarks. In Europe, 88% of institutions say this is true, as do 86% of Asian institutions and 80% of institutions in North America.

As institutions forgo relative performance measures and instead focus on meeting their own specific investment fund objectives, passive investment products delivering market performance at a relatively low cost are becoming increasingly important tools in institutional portfolios. Worldwide, about one-third of institutions participating in the Northern Trust study say passive products make up more than 40% of their equity and fixed-income assets, and a sizeable number of institutions expect to increase allocations to passive strategies during the next three years.

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Choosing the Right Index

As institutions ramp up their use of passive strategies, they have begun to examine the construction and suitability of the benchmarks against which they manage. Participants in the study noted that market-cap coverage, style biases, weighting methodology and sector/country biases are the most important criteria they consider when evaluating and selecting an index.

In addition, many of the study participants (37% globally) expressed concerns that the use of traditionally constructed indexes in their passive strategies may affect their ability to achieve their goals. Specifically, respondents noted concerns about biases toward larger market capitalization in equity indexes. For fixed income, their concerns centered on biases toward larger debt issuance. Around the world, 63% of institutions participating in the Northern Trust study said that known inefficiencies should be addressed and removed.

These concerns are driving some institutional investors to seek new ways to achieve benchmark exposure, and more than half of the respondents (51%) said they would be interested in exploring customized indexes as a way to address their objectives.

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Broadening the Beta Spectrum

A new range of passive strategies has emerged, expanding from traditional/cap-weighted indexing to alternative indexes and, increasingly, customized index approaches. These new indexes are designed to help investors address their specific objectives.

A variety of newly coined terms describe these efforts, including smart beta, intelligent beta, engineered beta and others. On a spectrum of beta, these methods — which Northern Trust refers to as customized beta — encompass exclusions, tailored indexes and actively targeted strategies.

Institutions in the Northern Trust study see two primary benefits to a customized beta approach: improved risk/return trade-offs and increased diversification. Beyond these, institutions can use customized beta to meet a number of goals, which differ somewhat by region.

European institutions:

• See the potential to boost transparency within their passive portfolios at a time of increasing oversight and regulation.
• View customized beta approaches as a way to provide an efficient screening tool for complying with socially responsible investing (SRI) and environmental, social and governance (ESG) investment practices.

Asian institutions:

• See customized beta as a possible tool for eliminating inefficiencies they see arising from methodology and weightings biases of existing indexes.

North American institutions:

• Although passive funds make up a smaller share of institutional portfolios in North America, many institutions that are planning to increase their allocations to passive strategies see customized beta as a means of expanding their market coverage at the same time.

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The Future

Despite the broad trend toward passive investing, the market remains segmented, with some investors gravitating toward traditional index solutions while others are exploring the possibilities of custom indexes. In the future, institutional investors may consider a broader range of approaches when selecting indexes as they become more familiar with the potential benefits of customized beta.

The spectrum of beta-to-alpha solutions is broad, providing an excellent opportunity for institutions to review their investment goals, and to explore opportunities to refine alignment between the pursuit of beta and those goals.

To read a full copy of the study, visit www.northerntrust.com/morebeta.

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