Indexing of pension fund investments, once derided as a fad that would fade, has continued to grow faster than pension assets overall, so it's no fad. But it's not a threat to the capital markets either, as some investors fear. It is, however, a warning that active equity managers must do more to justify their fees.
As the most recent Pensions & Investments survey of index fund managers elsewhere in this issue shows, indexed assets surged in 1995 - when both the U.S. equity and fixed-income markets had big returns. Indexed equity assets grew net of those market returns, and they grew especially in the fourth quarter, suggesting plan sponsors indexed after being disappointed by their managers in the first three quarters.
Preliminary figures from SEI Corp. show the median equity manager underperformed the Standard & Poor's 500 Stock Index's return of 37.6% in 1995 by 410 basis points, returning 33.5%. At the end of the third quarter, the median manager was 200 basis points below the index.
Over the longer term, active managers have just about matched the index. For five years, the median return was 16.5% vs. 16.6% for the S&P 500. Clients are not paying active management fees to match the index. But such figures do not tell whether individual managers are earning their fees. If the managers are the market, then the median manager cannot beat the market. We must look further into the methods and the performance figures of managers to determine their worth.
Managers must refine both their processes and communications with their clients. Managers must, first and foremost, continuously re-evaluate their investment methodologies to ensure they are consistent with the ever-evolving capital markets.
There are few, if any, immutable laws in investment management. No model, no methodology, has proven itself infallible through time. If one had, all investors would have migrated to it long ago, and all would be immensely successful. But all models and methods must be tinkered with to keep them fresh. The successful money manager cannot afford to stop learning from the market, from theoreticians, from competitors and even from clients.
Clients must make changes, too. More must adopt new, more sophisticated ways of evaluating their managers. Many large clients already measure their managers, not against the S&P 500, but against custom benchmarks tailored to each manager's own target universe of stocks. So, each manager is measured not against the broad market, but against the performance of the kinds of stocks he or she is likely to buy. This approach measures a manager's ability to select stocks that will outperform the target universe, and allows for when a specialty manager's target universe might be out of favor with the market as a whole.
More clients must also measure the performance of their managers on a risk-adjusted basis. Many managers who underperformed the broad indexes might well have beaten the index when their results are adjusted for the fact that their portfolios were less risky than the market.
As for concern that indexing will distort the capital markets, it is a long way from reality. Total indexed equities account for only 28% of all equities of pension funds and a far lesser part of the total equity markets.
Indexing is a useful supplementary investment approach; it is a simple yardstick for performance that should not be relied on alone; and it is a useful spur to clients and managers alike to improve their techniques.