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Active design seen as next wave in passive management

The index-based fund management boom hasn’t negated the need to customise portfolios. As investors demand increased transparency and competitive fees, a new solution is drawing interest.

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 embraced these strategies.

This evolution, however, has not addressed concerns among some institutional investors about composition of the benchmarks.

One factor fuelling demand for index products is a school of thought that holds there are fewer opportunities for investment managers to outperform market indices, particularly in developed markets.

Active managers argue that markets are inefficient and that 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 overall market return, or 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 guidelines.

Investors and portfolio managers have cited challenges with equity index weights determined by market capitalisation or fixed-income index country weights driven by security issuance and not by desired risk parameters.

Fundamentally weighted indices and other weighting schemes 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,” says John Krieg, managing director for Europe, Middle East and Africa at Northern Trust based in London. “A number of market participants have highlighted the need for a more effective approach.”

Currently investors spend a high proportion of their time on asset allocation, deciding whether to choose active or index managers, then selecting and finally monitoring the chosen managers. Relatively little time is spent on analysing the index itself.

Investors are beginning to question the basis of traditional index construction as they look to achieve their distinct risk/return goals.

“Investors are familiar with customising investment guidelines to meet exacting requirements, but often use an ‘off the peg’ index when they could have a customised index,” says David Rothon, fixed-income investment strategist at Northern Trust in London.

New approach
This has given rise to an approach where the worlds of active and index management merge. In an actively designed, passively managed investment strategy, minor modifications to conventional index strategies or more sophisticated weighting are utilised.

What is the outcome of actively designing an index for desired exposure and then passively managing the portfolio? Investors using this approach benefit from the risk efficient and cost effective nature of index management while achieving desired market exposure to meet investment objectives.

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.

Fixed income indices, for example, 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 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 that the same issuers have a lower rated credit quality as a direct result of servicing this level of debt,” explains Rothon. “For example, Spanish and Italian government bonds represent nearly 35% the Barclays Euro Treasury Index.”

From simple to complex
The active design component of these strategies can be simple: the starting point would be the traditional index, followed by a discussion on the risk factors and exposures the investor wants to screen or modify.

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 Eurozone periphery, such as Italy and Greece.

The pension fund opted for a custom index focused on the most creditworthy 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 undesired issuers. As a result of the active benchmark design, the portfolio out-performed the broad market index – a result 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,” adds Brad Adams, senior product manager at Northern Trust in Chicago.

He outlines how 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 customised benchmark designed to match the investor’s liability stream,” he 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 customised index comprises four components. The first consists of bonds from a specific list of highly liquid US Treasury-stripped securities that reset once a year to match changes in the investor’s liability stream.

The 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, credits and treasury inflation-protected securities.

“With the proper balancing, the four components end up matching the benchmark and the liability stream through a passive strategy”, says Adams.

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 customised way. It all comes back to what risk/return exposure investors want and designing a solution to match that.”

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