A new dawn for passive investment

In the current climate, the global investment community is undergoing a gradual shift from active strategies to passive management.

Achieving alpha and outperforming industry benchmarks, which have come to be expected but not always achieved by active managers across the globe, is now being replaced amidst the global economic downturn. At the same time the global investment community is now displaying renewed needs for transparency and reliability.

Given this, passive management models, such as indices, which are used to mirror the market performance, are once again in the limelight for both institutional investors and individual asset owners.

The dilemma that asset owners and high net worth individuals are currently facing is: what allocation and which tool? With increasing fees, investors are shying away from reliance on active managers and moving towards tools such as tracker funds.

Within this, indexing plays a vital role in providing investors with investment opportunities in a transparent, risk managed and cost effective way. On the institutional front, this strategy is symbiotic with that of the long term outlook deployed by pension funds.

However, it is important to note that index innovation over the last few decades now also caters for individual investor needs and the ability to use indices and related products in much the same way as active managers have in previous years. Through such innovation, index providers including FTSE Group, have been able to draw on the recent success of active strategies, wrapping them into risk managed and often customised indices.

In this way, investors are able to draw upon specialist index providers to create tailor-made solutions, helping keep costs low and ultimately seek out better performance in both market downturns and booms.

Investors and indices

From its humble beginnings the index has grown to be much more than a value which represents the performance of a group of companies. Though a common misconception, indices are now also much more than a simple country benchmark, such as the FTSE 100 and FTSE Group now calculates over 120,000 indices worldwide across a range of continents, investment themes and strategies.

Investors need to understand that an index cannot be invested in directly, but that investment is made within an index fund. Such funds are the basic investment products bought primarily by investors’ eg mutual funds or exchange traded funds (ETFs) and mirror the market they are stated to represent.

These funds are a common way for individual investors to take advantage of an index, providing a cost effective and simplistic way of accessing a basket of stocks within any given index.

Changing role of the Index

The current environment has created a significant opportunity for index providers with a new resurgence from investors for index tracked investments.

Index providers such as FTSE Group, are now working more closely with institutions such as stock exchanges and specialist investment organisations, to create new regional and partner indices for market exposure. This offering includes an expansion of the FTSE Global Equity Index Series, to include rapidly growing frontier markets. Going forward and through differing market capitalised indices, it will be vital for investors to spread investments globally, diversifying between clearly and objectively defined developed and emerging markets.

The main benefit of indexing is that it provides a low cost way for index fund investors to achieve the returns available in a given market, without worrying about trading individual stocks or positions. As the popularity of index investing has grown, so too has the number of indices. With thousands of ways to ‘slice and dice’ the world of investment, if there is a market or market segment, there is probably at least one index that tracks it.

In the past few years’ creation of newer and more innovative ways to benchmark both existing and new asset classes has become a key priority for index providers.

Just as importantly, the range of products available to investors in addition to tried and tested market capitalised indices, including new themes and strategies and products created off the back of indices has grown considerably, such as the explosion of ETF activity.

Investment strategy indices

Wealth based indices such as the FTSE RAFI Index Series and FTSE GWA Index Series’ have grown significantly in popularity. These indices look at factors such as; dividends, cash flow, net earnings and book value.

As wealth weighted strategies behave differently to market capitalisation-weighted indices, over the longer term they are often believed to outperform. This is because they do not systematically overweight overvalued stocks or underweight undervalued stocks – hence staving off the effects of bubbles.

Whereas the traditional approach to adding value to portfolios has been to incorporate sector bets within traditional market capitalisation benchmarks. Wealth weighted indices provide an efficient form of diversification and are therefore seen as a portfolio diversifier, used across the globe by some of the world’s largest funds.

Recent index innovation also include inspiration from active strategies, taking methods investors have experienced over the last few years and making these transparent and cost effective.

FTSE Group has recently expanded its investment strategy indices to include short and leveraged indices, such as the FTSE 100 and FTSE 250 short and leveraged index series. These indices create opportunities for investors to short the market or gear up and are favoured for their ‘all weather’ ability.

Alternative and thematic investment

Against the current backdrop, investors are now more than ever seeking diversification to reduce risk of excess volatility in returns. This has prompted a move away from a reliance on traditional asset classes to consider alternative asset classes and approaches.

Most recently, there has been a significant development in the field of responsible investment, where investors are now looking for sustainable long term returns. FTSE Group has responded to

this demand with the expansion of the FTSE Environmental Opportunities Index Series covering for the first time new sectors such as Water Technology and Energy Efficiency. The creation of new ways to benchmark has not stopped at existing asset classes either.

Alternative asset classes such as real estate investment trusts (REITs) have come a long way to provide investors with greater choice, access and diversification.

Indexing and the ETF

Over the last few years, ETFs have evolved to become an investment tool of choice across the globe. Nowadays they are regarded as a straightforward, low cost and flexible way to access the potential rewards of the market.

With such a rapid pace of growth and a magnitude of funding, ETFs are now available for almost every niche and market, due to index providers’ ability to create customised indices. These allow individual investors to explore new and inventive ways of investing.

As ETFs are designed to sit on or track an underlying index, they are often based on an accepted benchmark, with the index contributing to the market acceptance and understanding of the investment opportunity.

FTSE Group works with leading ETF providers and believes that an independent rules-based index design provides the market with the highest level of transparency and confidence needed, while index liquidity rules ensure a more than acceptable level of ETF liquidity.