Index investing - not necessarily glamorous, but effective

Damien Frawley maintains index investing is still fresh after four decades.

It is widely accepted that the phrase 'May you live in interesting times' is an ancient Chinese curse. Actually, it is neither Chinese nor ancient in origin, but is instead recent and Western.

Regardless of the origin of the words, there is no doubt that investors do indeed live in interesting times.

The global financial eruption of 2008 and continuing aftershocks have jolted investors in a fashion not experienced for many decades. As a result, long-standing beliefs are under question, including the conviction that equities offer higher returns than other conventional asset classes over the long term.

In 2011 investors have been de-risking their portfolios by flooding into cash (including term deposits) and fixed interest, and this trend will probably continue in 2012.

Index investing has also benefitted from changed investor attitudes. According to Rainmaker, index funds as a whole represented 13.2 per cent of total investment industry funds under management at the end of June 2008.

By the end of June 2011, the index funds market share had climbed to 15.8 per cent¹.

Intriguingly, Australian and global equity indexing enjoyed something of a bull run over those three years.

Index Australian equities represented 15.4 per cent of the total industry funds under management at the end of June 30, 2011. Three years earlier, this figure was just 11.2 per cent².

Global equity indexing has received even more support, capturing 23.1 per cent market share by June 30, 2011 compared to 15.4 per cent three years earlier³.

We see this migration of funds into indexing as something more complex than all-out de-risking. Instead, we believe it implies investor sophistication.

Rather than retreating by taking shelter in cash and fixed income, a large number of Australian investors have positioned their funds in a way that underlines a belief in the importance of maintaining some equity exposure.

They may be cautious about the outperformance potential of equities at this time, but have not given up on the conviction that equities are worthwhile in their portfolios.

So indexing may be a kind of parking bay, a place from which funds will flow back into active investments when greater confidence about the global economy returns. 

Not glamorous, but effective

Senator Ron Boswell made a name for himself during the 2001 Federal election with billboards and television ads saying, “He’s not pretty but he’s pretty effective”.

As it turned out, he was successful in winning senate re-election on that note of self-deprecation.

Similarly, indexing as an investment approach may lack the panache of high alpha-seeking strategies.

However, it has carved out a large slice of the global and Australian investment pie because its attributes are as compelling as they are simple.

Hard as it may be to believe today, the advent of indexing in 1971 was a breakthrough. Making the world’s markets accessible in a cost-competitive way was a significant boost to the diversification cause for investors everywhere.

Advocates of indexing and active investing were at loggerheads for some years. Each side substantiated their views, trying to demonstrate that their opponents’ arguments were flawed.

Thankfully, the industry has moved on. Discussion these days is about index as well as active. Together, they can potentially achieve better outcomes for clients than either can in isolation. 

Barbelling puts indexing front and centre 

‘Barbelling’ has brought an end to the index - active wars. Today, high conviction strategies at one end of the portfolio barbell are being complemented by lower -risk index strategies at the other end of the barbell. 

By separating beta from alpha in this fashion, advisers can now define risk budgets as well as performance targets more transparently. They are also better able to gauge manager skill.

The emergence of barbell investing also reflects a re-examination of the fundamental law of active management⁴, which describes the relationship between an active manager’s risk-adjusted return (or information ratio), their skills or insights and breadth of the strategy, or how many times their insights can be applied.

Wider and deeper

In recent times, breadth - which can also be thought of as investment decisions driven by many independent sources of active return - has been the predominant focus of attention, and for good reason.

Greater attention on the skill element of the fundamental law is opening up a world of active strategies, such as long-short investing, where risk is only spent on unique, high-confidence insights.

The same approach can be applied to manager selection.

Rather than investing in active managers with modest alpha targets, barbelling is premised on employing high outperforming-seeking managers with low correlations. Risk and cost budgets can be managed by combining high alpha managers with index tracking, or low risk, lower cost funds.

As we kickoff 2012, barbelling promises to be one innovation that may be as long lived as indexing.

Damien Frawley is head of BlackRock Australia.

¹ Rainmaker Roundup (Edition 55) June 2011 (printed September 2011).
² Ibid.
³ Ibid.
⁴ Grinold and Khan 2001. A manager’s value-added (information ratio) is a function of his selection skill (information coefficient) and the number of opportunities (N) he has.