Advantages of indexation add up

If they choose the right indices and the right vehicles, wealthy investors can gain many benefits from the growing number of indexed funds.

Wealthy individuals are emulating institutions, moving towards the core-satellite model of an indexed core with satellites invested in active funds and strategies. According to David Blitzer, chief investment strategist at Standard & Poor’s (S&P), there are two key points behind the benefits of indexing. First, the difference in fees, which is more pronounced in the US than in Europe. “For a passive fund, an index retail fund charges 9-10 basis points (bps), 9.5-12bps for an S&P exchange-traded fund and 25-50bps for a large-cap fund,” he says. “Then 75bps are charged for a sector-based or small-cap specialised index fund. With an active fund, the fees are 75bps for a plain vanilla fund, growing to 200. So you have a 100bps difference just to start with.” These figures are for the US but the pattern is the same in Europe, he says. The second point relates to long-term performance. “In the US, only one third of active managers can outperform the S&P 500 each year. Over five years, the figure is just one in five,” says Mr Blitzer. Just two or three managers, including Bill Miller of the Legg Mason Value Fund, have succeeded in beating the index year in, year out. “If it were easy, they wouldn’t be so famous for it,” says Mr Blitzer. Another issue is availability of information. Mr Blitzer’s argument is that, post-Enron, anyone buying an index fund can access comment and analysis from a range of writers, whereas, with a single active manager, only that manager writes about his own fund, so there is very little independent comment. Big names such as Barclays Global Investors (BGI) and State Street Global Advisers run index funds, specialising in money management and, according to Mr Blitzer, leaving the client management to financial planners and brokers. However, there is a growing trend towards a slightly different type of management. S&P works with US organisations such as California-based Assetmark, which is active in client service for index fund providers. It uses seven strategists, including S&P, to do the money management. “As soon as management and service are unbundled, the cost advantages of indexation start to add up,” says Mr Blitzer. There is some debate about whether indexing is appropriate for small caps but Mr Blitzer is convinced that active does not have an edge even here. “Even if more small-cap managers outperform, it does not make it any easier to choose a successful small-cap manager,” he says. “Even if half of them outperform, which half are you going to be in?” Free float Free float, providing the ability to issue, trade and balance pricing at any minute of the day, rather than on a once daily basis, has implications for investors. Peter Jeffreys of S&P Index Services says: “Before the free float, it was hard to replicate the index because, with certain indices (for example in Finland), you would have to buy twice as many shares to get the correct exposure. “Because 70 per cent of the index is Nokia but only 50 per cent of the shares are available, you would have to buy more shares than should have been the case.” Now, in theory at least, this is smoothed over by the possibility of more issuance. The Japanese index, for example, is now replicable. However, UCITS regulation, which allows only up to 10 per cent to be held in one stock and 40 per cent in eight stocks, still prevents replication of the Finnish index. Similarly, the top 10 stocks account for 70 per cent of the Italian, Belgian, Dutch and Spanish indices. The most popular, most liquid indices are the FTSE 100, CAC40 and DAX, which are tracked through exchange-traded funds (ETFs) from BGI, Société Générale and Hypovereinsbank, respectively. Chossing an index Investors need to consider several key factors when it comes to choosing an index. One is performance, in terms of both risk and return, although comparative data can be hard to come by. Another is the availability of investment products: can you buy an ETF, for example? And a third is the availability of information on the index. “The investor wants to understand what he or she is buying,” says Mr Blitzer. “He or she needs to look at the publicity material and the website and the overall reputation of the provider.” It is also important to ask how long the index provider has been in the business and what their commitment to it is. Brand is a factor but the construction and technical back-up are far more important, according to Mr Jeffreys. Tracking error is becoming more important and it is critical that investors look at the tracking error of individual stocks – the more liquid they are, the less likely there is to be a significant tracking error. It is also important to find an index with frequent net asset value (NAV) calculations, says Mr Jeffreys. “ETFs have been good for investors who want broad access at a low cost to the stock market,” says Mr Jeffreys. “You can trade ETFs in a highly efficient manner at any minute of the day. ETFs are also very close to NAV whereas, because of daily pricing, orders for funds can be filed at a discount or premium to NAV.” High net worth individuals’ use of ETFs is already common in the US as part of a core strategy and as an alternative to futures. Investors can also go short with ETFs, if they have the requisite know-how. “So there is the possibility of hedging the portfolio to take out market risk. You hold the shares and short the ETF,” says Mr Jeffreys. But, he warns, this is not for first-time buyers or unsophisticated investors. ETFs tend to be fairly straightforward, based on a single index, style or sector. However, Mr Jeffreys says that in the future, geared ETFs and options on ETFs can be expected. DWS in Germany has been experimenting with active ETFs. Certainly, as an asset class, ETFs are widely expected to grow. “The influence of ETFs on the wealth management industry is only just beginning,” says Mr Blitzer. “Three or four years ago, they were just a curiosity. Now, due to BGI, almost any asset allocation can be replicated through ETFs.” Alternative indices S&P is developing a hedge fund index this year, for which it is now reviewing funds. “Hedge funds are about absolute returns and controlling,” says Mr Blitzer. “There is not a lot of transparency in this particular industry. This benchmark will give hedge funds more interest and acceptability.” The funds are judged not purely on size, but through statistical analysis of performance and overall experience of the managers. “Our goal is to provide credible funds that will represent a sector in hedge fund indices; we are not placing bets on the funds. It is essentially the same kind of selection we use for stocks in one of our traditional indices,” says Mr Blitzer. FTSE and Dow Jones have both launched ethical indices but S&P has no immediate plans to follow suit. “We are looking at ethical indices,” says Mr Jeffreys. “But they mean different things to different people. There is no consensus on what constitutes environmental investments.”