The California Institute of Technology, Pasadena, and University of Texas, Austin, are among the larger endowment funds that have used indexing to boost returns and decrease costs in their core domestic equity portfolios.
Given the charging bull market of the last few years, many endowment funds are eyeing the rewards offered by indexing. And though there hasn't been a flood of endowment funds flowing into indexing, more endowments are willing to passively ride the rising tide of Wall Street, money managers and fund officials say.
Indexing large-capitalization domestic equities has proven an attractive option for the approximately $1 billion endowment at the California Institute of Technology, Pasadena.
"We looked at indexing, and after reading all the research that's out there, a few months back we basically concluded that it made sense to index more of our large-cap domestic stock portfolio," said assistant treasurer Sandra Ell.
"It's more difficult to make that argument in small-cap and international," she said, "which I suppose is chapter and verse in current literature. As well, we currently have on the drawing board an in-depth style analysis of our domestic equity portfolio, which will likely be our next project. But in general, we think that it makes sense to have a fraction of your domestic equity large-cap portfolio in an index."
At the University of Texas Investment Management Co., chief investment officer Thomas Ricks added that his endowment has invested approximately 40% of its U.S. equities allocation in indexed funds. "We use indexation on our core U.S. portfolio," explained Mr. Ricks.
"We don't currently have a view of either increasing or decreasing that amount. It's a pretty stable part of our portfolio. Our U.S. equities constitute about 35% of our managed assets of $8.5 billion."
Mr. Ricks added that the endowment's indexed assets are primarily midcap and large-cap stocks. But officials there believe active managers of small-cap and international stocks can produce better results.
Michael Dalis, vice-president of State Street Global Advisors, Boston said: "Pretty much across the board with the smaller endowment funds we're seeing more of an interest in indexing, with the possible exception of international.
"For smaller funds, there's been a big push for the S&P 500 as well as a strong demand for bond indexing. For larger funds, it's a little different. In terms of U.S. equities, we're seeing interest in broader indexes beyond the S&P 500. There's the inclusion of midcap and small-cap securities, as well as mandates for the Russell 3000 and Wilshire 5000. We're also starting to see some interest in some style indexes. In the international side, we're seeing the use of many custom benchmarks that are not necessarily the Morgan Stanley EAFE but rather something they've created off of the EAFE."
State Street oversees approximately $11.9 billion for foundations and $1.7 billion for endowments.
"I would say that, on balance, we are finding more endowment funds flowing from an active to passive approach, particularly in terms of their core equity exposures," explained Leroy Cody, senior vice-president at American Express Asset Management, Minneapolis.
"You can hardly blame anyone for doing so. Given what's been happening in the market over the last 10 to 15 years, it certainly appears tempting for many institutional investors."
American Express manages approximately $1.6 billion for endowments and foundations, approximately $159 million of which is in "an enhanced product tied to stocks in the S&P 500."
James-Keith Brown, managing director at Bankers Trust Co., New York, said he has seen endowments move toward indexing over the past two years. "We're certainly seeing a trend to indexing, particularly of core assets, especially among the larger endowments of over $1 billion and the smaller ones of less than $100 million," he said.
He explained that smaller endowment funds tend to view indexing as "purely a fee issue. And with the markets performing the way they have, it's been difficult to outperform their benchmarks and indexing strategies are a lot cheaper. We do both, so we don't have a bias. But we're seeing smaller endowments tending to focus on key managers who have really done well for them on the active side, and indexing the other portion."
Mr. Brown said endowments still believe that small-cap and midcap managers can outperform the index. He added that enhanced strategies also are gaining popularity, in addition to regular indexing.
Bankers Trust manages approximately $4.5 billion for endowments and foundations.
Yet not all endowments share in the enthusiasm for indexing.
"It (a move to indexing) is not happening in our case," said Jim Bookout, chief financial officer for $150 million endowment fund at Florida State University, Tallahassee.
"As a matter of fact, it wasn't long ago that we hired new active managers in the areas of small cap, international, value and growth.
"We are still supporting our investment strategy to be a little
more aggressive than indexing. We have an allocation of 60% equity and 40% fixed income, which is somewhat on the conservative side.
"But to attain a higher return within certain risk limits, we've gone to international and to small caps. Prior to that, we were mainly in large-cap growth and large-cap value."
Various forms of indexing are gaining popularity with endowment clients of Barclays Global Investors, San Francisco.
"We're seeing an increase in indexing requests coming from consultants on behalf of endowments and foundations," said Barclays' Managing Director Kathleen Dunlap. "We manage about $13.5 billion for endowments and foundations, and that figure was about $9 billion one year ago. Although a good portion of that is due to the market rising, we've also seen a noticeable increase in investment from endowments and foundations."
Ms. Dunlap added that many of her firm's endowment and foundation clients have shown a "definite increase in quantitative management or disciplined management, though not necessarily indexing. We've seen the assets spread over all of our products including indexing, advanced active products and perhaps, most surprisingly, tactical asset allocation."
Ms. Dunlap said endowments are moving toward indexing because of costs, "disillusionment with their active managers because of poor performance" and because they are seeking a disciplined investment approach.
"Our enhanced active product is an alpha strategy and can be benchmarked against any benchmark. It involves moving actively between indexed funds. It's basically designed to add about 100 to 200 extra basis points of return on average per year. The cost is about half that of an active manager, but more than an index fund."
Endowments' relatively recent attraction to indexing comes on the heels of corporate funds' longer-standing interest in passive investment.
"Corporate funds, on the pension fund and operating sides, looked at indexing earlier than endowments did," explained Bankers Trust's Mr. Brown. "Endowments and foundations were earlier to enter into alternative investments than corporations. But recently we've seen a bit of a reverse trend, with corporations and public funds starting to examine more alternative assets, which endowments have already been involved in."
Mr. Brown added that larger endowment funds now are adding fixed-income indexing to their portfolios. "While it's not as large a trend as the equity movement, we've seen increased interest in that area as well," he said.
The consensus among index managers is that endowments' move towards indexing will continue over the next few years. "Non-profits, in general, don't have huge amounts of money to pay for active management, so indexing works well for many of them," explained State Street Global Advisors' Mr. Dalis.
"I think strong demand for indexing will continue, although in terms of the plain vanilla benchmarks, demand may decrease. I think even the smaller endowments will eventually show more interest in different kinds of benchmarks."
Added American Express' Mr. Cody: "The trend will likely be in place as long as the performance of the indexes within the manager universe continues to be very strong."