Enhanced indexing works
Our firm has been following separate account enhanced index strategies since 1991, when very few managers offered such accounts. Our most recent review found about 50 managers and strategies (some with live track records going back to the early '80s) which purport to be enhanced indexed. Contrary to the results attributed to Ibbotson Associates in the Aug. 5 article "Enhanced indexing rapped," we are familiar with some genuine enhanced indexers who have consistently added 1% to 1.4% (gross) in annual excess returns with 2% annual tracking errors. (Of course, some enhanced index firms do better and some do worse.)
We consider only those strategies which either: pick stocks but use an optimizer to construct portfolios that take limited controlled bets against the benchmark; buy stock index futures and manage short bonds with duration, sector, quality bets; use a combination of futures plus various risk limited arbitrage strategies to produce enhanced cash returns; or used constrained growth rate maximization (for stocks). We do not included swap or long-short strategies. Not only have we found that enhanced indexing generally reduces the likelihood of taking big, poorly understood bets, but performance is repeatable over three- to five-year periods, and the processes can survive turnover within the management firm. While it is true that all these strategies involve characteristic risks, and also true that none of the risk models is complete, enhanced indexing takes fewer and smaller risks than is typical of outright active management.
One reason that Ibbotson-managed results may differ is that some of the better enhanced index managers have not offered mutual funds. We expect that when Ibbotson looks at managed accounts instead of mutual funds, its results will be more positive.
Alan D. Biller
Alan D. Biller & Associates Inc.
Palo Alto, Calif.
Value of enhanced index
A recent study by Ibbotson Associates, Chicago, concluded that "enhanced indexing is neither." The study, however, looks at enhanced indexing in a vacuum. The value of including a new asset class or manager in a portfolio depends not on how they perform in isolation but on how they correlate to the existing portfolio. The Ibbotson study does not compare enhanced indexers to traditional equity managers and thus fails to address a key reason and major benefit of this style of management: diversification of value-added or alpha.
As the Ibbotson article correctly pointed out, enhanced indexing is in the eye of the beholder. There is, as yet, no generally accepted definition of enhanced indexing, which encompasses many diverse strategies described in their study. However, because any strategy that attempts to outperform a benchmark, such as the Standard & Poor's 500 Stock Index, must take risk, enhanced indexing and traditional active equity management will have similar elements.
The correct questions, then, pertaining to the value of enhanced indexing become:
a) is better risk management apparent among enhanced indexers when compared to traditional styles;
b) does enhanced indexing provide superior, similar or lower returns per unit of incremental risk taken; and
c) by combining traditional with non-traditional equity managers (such as enhanced indexers), can overall portfolio performance be enhanced?
Our firm's preliminary empirical research into the performance of traditional equity managers vs. enhanced index approaches highlights these issues.
To compare performance characteristics of these two styles, we first calculated the annualized average and standard deviation of their returns in excess of the S&P 500 (alpha) and found the following:
One hundred seventy-nine traditional managers had an average annualized alpha of 0.95% with a standard deviation of 6.94%. The level of alphas ranged widely from -7.54% to 16.25%.
Thirteen enhanced index managers had an average alpha of -0.25% but with a significantly lower standard deviation of 3.32%. The range here also was much narrower, from -5.94% to 2.91%.
On a risk-adjusted basis (alpha divided by standard deviation of alpha), the average alpha for traditional managers was a mere 0.07% but a more significant 0.26% for enhanced indexers.
Both sets of managers, on average, had betas with respect to the S&P 500 of 0.99 and so both on average have a risk level comparable to the S&P 500. However, the average correlation of traditional manager returns with the S&P 500 was only 0.82 compared with a higher average of 0.93 for enhancers, showing their tighter index tracking ability.
These results would seem to indicate enhanced indexers are true to their name in offering more consistent performance and tracking their benchmarks more closely than traditional managers.
The evidence shows virtually all of the most attractive strategies are enhanced index strategies (with one exception, which was a traditional active manager with only a few quarters of history).
Not only have enhanced index strategies performed well on an absolute and relative basis, they have low correlation of alpha with other more traditional managers. For example, the average correlation of excess return of these more traditional managers with some enhanced index strategies was -0.14. The average standard deviation of traditional managers' alpha was 6.94% compared to 3.32% for enhanced indexers. Thus, a 50/50 mix of an enhanced index strategy and another traditional manager could, on average, cut the volatility of relative performance roughly in half.
We found the results supportive of enhanced indexing strategies in general, contrary to the Ibbotson article. The name "enhanced indexing" may be vague and ill-defined (not unlike "market neutral" or "risk arbitrage") but it encompasses strategies worthy of consideration in any equity portfolio.
Matthew Smith
Lotsoff Capital Management
Chicago
Disappearing ETIs
In the Others' Views article, "Disappearing ETIs, or just a new definition" (Pensions & Investments, June 10), D. Jeanne Patterson says that economically targeted investments "will now be considered alternative investments, rather than economically targeted per se." She also asks whether "alternative investments (are) taking the place of ETI" and quotes fairly extensively from the 1995 Survey of Alternative Investments by Pension Funds, Endowments and Foundations, conducted by Goldman, Sachs & Co. and Frank Russell Capital Inc.
This conjunction of ideas could be misleading. It is important that we not confuse alternative investments with economically targeted investments. While the Goldman/Russell survey did include "targeted investments" in its definition of alternative investments, only a tiny fraction - 2.4% -of the $69 billion committed to alternative investments was specifically allocated to ETIs.
Thomas J. Healey
Partner
Goldman, Sachs & Co.
New York
Kleinwort Benson
Kleinwort Benson Investment Management Americas Inc. was not listed in your May 13 directory of money managers, although we have been included in past years.
The firm is an active international and emerging markets equity manager. It has $1.2 billion under management as of March 31, of which $717 million is U.S. institutional tax exempt. It had $581 million in international equity and $136 million in emerging markets equity for U.S. institutional tax-exempt clients.
For international equities its investment approach is bottom-up and seeks to identify undervalued growth stocks using intensive research methods.
For emerging market equities its investment approach uses a two-tier, fixed weight, core strategy combined with integrated risk management and both top-down and bottom-up analysis.
The parent company is Dresdner Bank.
Peter J. Ellis is chief investment officer; Lauren R. Teel, director, is client contact at (212) 351-5800.
Kimberly Fusaro
Assistant vice president
Kleinwort Benson Investment
Management Americas Inc.
New York
Babson-Stewart
In the June 24 issue of Pensions & Investments there was a ranking of the overseas managers, Babson-Stewart Ivory International was not included in the listing. Due to the wide readership of Pensions & Investments, we feel strongly about being included in this listing.
Babson-Stewart Ivory International is a partnership between David L. Babson & Co. Inc., Cambridge, Mass., and Stewart Ivory & Co. Ltd. Edinburgh, Scotland. Babson-Stewart Ivory International has $568 million in international/global assets as of March 31 for U.S. institutional tax-exempt accounts. The firm has $437 million in international accounts and $197 million in global equity accounts.
Mary K. Guy
Vice President
Babson-Stewart Ivory
International
Cambridge, Mass.
Warburg PincusWarburg Pincus was not in your Aug. 5 directory of managers of defined contribution plan assets. The firm invested $1.1 billion for defined contribution pension plans as of Dec. 31; all of the assets are managed internally.
Of the defined contribution assets, $850 million is from 401(k) plans and $250 million is from profit-sharing and money purchase plans. The assets are invested as follows: $875 million in mutual funds, $25 million in variable annuities and $200 million in separate accounts.
The asset mix as of Jan. 1 was 90% stocks, 10% cash.
I am the client contact and can be reached at (212) 878-5680.
Brady T. Lipp
Warburg Pincus
New York
Ezra Zask
I would like to point out an oversight in the listing of derivatives consultants in the July 22 issue.
My firm, Ezra Zask Associates Inc., is a leading provider of derivative consulting services to banks, corporations and pension funds.
We are active in litigation support, training and consulting in risk management, value-at-risk consulting and training programs on derivatives in the United States and abroad. Among our credentials are:
Ezra Zask served as the expert witness in the ABN-AMRO currency option loss of $70 million;
EZA Inc. was retained to analyze Dell Computer Corp.'s use of currency options;
The U.S. AID program has retained EZA to train Russian and Eastern European managers in the use of derivatives
As a commodities trading adviser, EZA manages funds in the futures markets for institutional clients; and
Ezra Zask is listed in the Intercapital Who's Who in Derivatives.
In addition, we have been active in presenting VAR seminars and consulting to banks.
We have 12 institutional clients.
I would appreciate our firm's inclusion in any future lists of derivative consultants.
Ezra Zask
Ezra Zask Associates Inc.
Norfolk, Conn.
