Index funds: Building predictability into portfolios

Cheap and pretty cheerful. That’s one way to describe the indexing market at the moment.

With investment returns predicted to remain subdued for several years, indexing may be a product whose time has come.

According to SSgA Australia’s head of global structured products Susan Darroch, indexing provides advisers with a valuable tool in an environment where investment costs are under scrutiny.

“With indexing as the core, it is a great way to get the market return, and it is cheap and reliable,” she said.

Investment Trends director Mark Johnston believes the recent market downturn and volatility are changing attitudes towards indexing throughout the planning industry.

“There is an increasing focus on lower cost investment options, which is a natural focus when people are losing money,” Johnston said.

“To date, indexing has been mainly institutional money but that is changing. Retail use is increasing and the ETF [exchange-traded fund] market is a big component of that.”

Never saying sorry

Although indexing may not be exciting, its proponents argue that unlike active managers, they are never forced to explain their failure to achieve market returns.

While the boom was supposed to be a good time for active management, the story is still the same now, according to Vanguard Investments Australia head of retail, Robin Bowerman.

“You can’t have it both ways. Active management always holds out the promise of outperformance,”

he said.

“The evidence is that most active managers will underperform in both growth and bear markets.”

Bowerman feels advisers need to view indexing as a cost-effective tool for accessing market returns and for the development of superior investment portfolios.

“We need to get past the idea of whether it is a good time for active management or not.”

Darroch believes the performance from indexing is more reliable.

“You know whatever the market does, the index

portfolio will do as well.”

It is an argument that proved to be very persuasive in rising equity markets.

In 2002, only 10 per cent of total assets in the US managed funds industry were indexed, but by 2008 this had grown to 17 per cent, according to Bowerman.

In terms of net cash flows, index funds received 32 per cent of inflows in 2002, but by 2007 this had reached 47 per cent.

In 2008, the Barclays Global Investors Year End ETF Market Review found listed index products were the only ones with a positive cash flow.

Risk management

From Bowerman’s perspective, indexing removes both the security and manager risks in the investment

equation.

“It only leaves market risk on the table and this is more than enough risk for the average investor to deal with.”

Although the performance of index funds may not have thrilled investors, it has fulfilled the promise made by indexing.

According to Darroch, most index clients are satisfied.

“Market cap index funds have performed closely as expected.”

The same cannot be said for active managers, according to Bowerman.

“Active managers find it hard to outperform due to fees. It is harder for active managers to outperform after climbing the fee hurdle.”

The downturn has highlighted the gap between the top and bottom active managers.

“With the volatility over the past year, the gap between active managers has widened quite a lot,”

Darroch noted.

In fact, disenchantment with the performance of active managers is encouraging more interest in indexing.

“A lot of advisers and institutional clients are very disappointed with the outcomes from active managers and are now much more open to using an indexing approach,”

Bowerman said.

What goes in the pocket

Australian financial planners are definitely cottoning on to the concept of indexing, according to Investment Trends analyst Dr Alex Woolaston.

He said the firm’s November 2008 ETF Report

highlighted this point.

“With indexing in general, 29 per cent of advisers intend to increase their usage of it with clients.”

Bowerman claimed indexing benefits advisers because it enables them to focus on areas where they can add value, rather than on trying to pick investment ‘winners’.

“Indexing has cost advantages advisers can utilise and it can also help their own business.”

He argued that financial planning should not come down to the individual adviser’s ability as a stock-picker or in selecting fund managers, but should be about the best way to tap into investment markets.

“If ever anyone needed a demonstration of the fact the market is driving returns, the last 12 months is it,” Bowerman said.

He believes advisers need to consider their value proposition, with indexing making sense “if it is about asset allocation and development of a strategic portfolio for clients”.

“The argument is not active versus indexing, but how to blend together assets for the best results for clients and the adviser’s business,” Bowerman said.

“From the adviser’s

perspective, indexing offers an opportunity to add value for clients and to change their business model.”

Advisers can also use indexing’s message about cost-effective fees in the current low return environment.

“Charging lower fees gives investors better returns. Fees are a real benefit, as it is what gets back to the investor’s pocket that matters,”

Darroch said.

Realindex Investments CEO Andrew Francis agreed that index funds offer a significant advantage in terms of costs.

“When cost is a big issue, Realindex funds have a great position to play in advisers’ and clients’ portfolios,”

he said.

Indexing is also a valuable tool for encouraging wary clients to reinvest.

“Using indexing can be a good way to get back into the market without having to take on the risk a particular manager’s view is right,” Bowerman said.

Fundamental versus traditional

With interest rising, the traditional approach to indexing has attracted some challengers.

Fundamental indexing is the latest development and it uses a different construction method for the index against which the fund is benchmarked.

According to Francis, the Realindex RAFI funds offered through Colonial First State invest in a different way to traditional index products.

“Realindex’s starting point is the belief markets are inefficient and price does not equal fair value,” he said.

These funds reflect “a company’s economic footprint using fundamental measures of size, rather than relying solely on market price”.

Realindex claimed the funds avoid the long-term price drag that comes with using market capitalisation.

Francis argued the Realindex style provides advisers with a valuable alternative.

“Managing a portfolio according to this approach makes sound, rational sense.”

He said returns from long-term back testing of the RAFI funds showed a 2 to 3 per cent return pickup.

“It is efficient indexing in an inefficient market.”

At times, the return differential between fundamental and market cap index funds can be significant, Francis claimed.

“The more inefficient the market then the greater potential to outperform a market cap index.”

Despite this, traditional indexers remain sceptical and claim fundamental products have been disappointing in the recent market environment.

“Fundamental-style index strategies have underperformed, but that is not due to the structure,” Darroch said. “It is due to the value tilt within fundamental index products.”

Market heavyweight Vanguard is unimpressed with the new kid on the block.

“In Vanguard’s view it is active management. If you want to have a value bias then pay an active manager,” Bowerman said.

He claimed the performance of fundamental funds was “well below the market, so it demonstrates that the notion it is a filter for poor performance in the market has been exposed as a

fallacy”.

Francis, however, strongly endorsed the benefits of fundamental indexing and believes advisers do not have to make a choice.

“Realindex funds are a complement to active management and can be used as the core portfolio. They also provide a complement to traditional indexing,” he said.

ETF market booms

While the choice of index funds is increasing, so are the ways to access the investment style.

An increasingly popular method for advisers and clients is via listed ETFs, with Barclay’s global 2008 ETF Industry Review finding the sector now holds assets worth US$711 billion on 42 exchanges.

The latest Investment Trends ETF Report noted a similar trend here and pointed out ETF use in Australia had almost doubled. In 2006, there were 9,500 users, but by 2008 this had increased to 19,000.

“ETF use has accelerated dramatically in the past two years,” Woolaston said. “It has been really rapid growth off a small base.”

Also, more investors intend using these vehicles, with the report showing 33,000 investors are planning to use them in the future. The primary drivers for this are diversification and low cost, with a small percentage of investors seeking access to overseas markets.

Planners are also increasingly interested, with the Investment Trends research showing 16 per cent intended to increase their use of ETFs.

Johnston pointed out that current users of ETFs are mainly self-directed and high-net-worth investors who found the product themselves.

“But that is likely to change. The research shows the indexing market is at an interesting point,” he said.

Fresh distribution channels

The growing interest in ETFs has not gone unnoticed by the big boys.

ANZ has decided to grab a slice of the action launching a new Online Investment Account that allows customers to buy units in SSgA’s SPDR S&P/ASX 200 fund.

Vanguard has also announced it is about to launch ETFs in Australia. It expects this to expand the market for index-style investments in the same way ETFs grew it in the US.

“The ETF market here has been very muted and that is partly due to the range of products available,” Bowerman explained.

“We believe more competition will grow the market. US research shows ETFs compete with listed shares rather than cannibalising managed funds.”

He said the rationale for launching ETFs in Australia was to provide advisers and clients with another avenue for indexed investing.

“They offer all the advantages of the indexed approach through the listed space,” Bowerman said.

“We have had clients and advisers who like the indexing approach but want to deal in the listed environment, so this is a good

solution for them.”

SSgA Australia managing director Rob Goodlad agreed interest in ETFs was increasing and pointed out that in the US they were increasingly being incorporated into model share portfolios and structured products, such as ETF warrants and contracts for difference.

“ETFs offer institutional and retail investors a passive allocation to Australia’s largest publicly listed entities without having to pay higher active management fees,” he said.

Darroch believes ETFs offer many benefits to

planners.

“ETFs for retail clients are handy as the expense ratio is very low. It is a great way to get a diversified portfolio in one transaction,” she said.

They also provide more transparency than managed funds.

“They have the advantage over unlisted products as you know at what level you got your exposure, not the day end or next day price,” Darroch noted.

Better or different?

While most ETF enthusiasts see these listed funds as a cheaper option for indexing, Francis is not convinced.

“You have to pay brokerage every time they are traded, so are they really cheaper?”

He also questioned the role of market makers in ETFs and pointed out that these funds can trade at a discount to fair value.

However, Darroch believes the size of the secondary market and the arbitrage mechanism used with ETFs meant they tend to trade reasonably close to fair value.

Francis also highlighted that paying commissions to advisers using ETFs was more complicated than when managed funds were used.

“ETFs are an alternative but they are not better. They are a choice but they are not better funds.”

Whatever the merits of the ETF structure, Bowerman believes advisers are becoming more interested in indexing as a tool for portfolio construction.

“We are finding a really strong change in adviser

attitudes,” he said. “Advisers initially thought indexing was a challenge to their business proposition, but it is about building good long-term portfolios.”

In particular, indexing provided a valuable tool for constructing ‘core plus satellite’ portfolios for clients. This is the approach taken by most large institutional investors, such as overseas pension and endowment funds.

Darroch agreed indexing is a cost-effective way to construct a portfolio.

“Core and satellites is a really good strategy for planners to use. It is quick and easy with the cheap core and then you can take bets around that. If you have got a core strategy, then you can take time to look at what else is out there,” she said.

Advisers can really benefit by taking this approach, according to Bowerman.

“Vanguard is an advocate of the core plus satellite approach where the core piece is about accessing market return. If you believe active managers can add value, then they can be blended with the indexed core,” he said.

Indexing can also be used as a cost-effective way to access asset classes other than equities, and Darroch believes this will be a major trend in the years ahead.

“What is changing in the index world is indexing is spreading into other classes as well,” she said.