Enhanced indexing is gaining users globally as money managers tailor investments to suit pension funds around the world.
Pension funds in the United Kingdom and on the Continent are showing strong interest in strategies designed around FTSE indexes, while U.S. pension funds are investing in vehicles designed to provide enhanced performance over the Morgan Stanley Capital International Europe Australasia Far East index.
Among recent institutional fund action:
* Pensioenfondsen Metallindustrie, Amsterdam, just hired three money managers for enhanced index mandates worth more than e1.6 billion (US$1.5 billion). Two managers for the $11 billion fund will run enhanced equity indexed funds benchmarked to FTSE North American equities indexes, and the third will manage an index-plus bond fund benchmarked to the Lehman U.S. government bond index. State Street Global Advisors, London, received a e1.1 billion enhanced equity index mandate, and Merrill Lynch Investment Advisors, London, a e375 million enhanced equity index mandate from the pension fund. Vanguard Group, London, will run a e280 million "index-plus" mandate, benchmarked to the Lehman U.S. government bond index.
* University Superannuation Scheme, London, hired Henderson Global Investors and Merrill Lynch Investment Managers, both of London, to run 450 million (US$652 million) in enhanced equity index mandates benchmarked to the FTSE All-Share index.
"We thought if we already had money devoted to indexing and could add 50 to 75 basis points in performance, it was worth it," said Peter Moon, chief investment officer of the 19 billion fund. "We decided to put 10% into (enhanced) indexation so that the characteristics of the fund will be like an index fund but with a slightly higher return," he added.
"It gives pension funds the path to get more efficiency in the way funds are managed," said Andrew Fraser, manager of global consultants at Henderson.
* MediBank, Sydney, a health insurance fund for temporary residents in Australia, has an enhanced equity mandate for its pension fund with AMP Henderson. The size of the mandate could not be learned.
Australians were early believers in enhanced indexing. AMP Henderson (AMP Ltd. is the parent of Henderson Global Investors) has been running enhanced equity index strategies for pension funds in Australia since 1994 and now has A$9 billion (US$4.5 billion) under management there in enhanced funds.
J.P. Morgan's strategies
J.P. Morgan Fleming Asset Management, New York, has developed global enhanced index strategies for U.S., U.K. and Japanese pension funds. The firm started the EAFE Research Enhanced index strategy a year ago and now also offers a U.K. strategy based on the FTSE All-Share index and one for Japanese investors based on the TOPIX index.
"When active managers were not doing well, funds started looking at enhanced products," said Nigel Emmett, managing director of J.P. Morgan in London. The firm now has $400 million under management for its enhanced EAFE approaches and $300 million under management for its U.K. enhanced strategy.
J.P. Morgan is in discussions with several potential Japanese clients. "The Japanese clients we're talking to would use it as a low-risk core product and have more active managers surrounding it," said Mr. Emmett.
Philip Menco, in-house consultant to Pensioenfondsen Metallindustrie, said: "We have quite ambitious ideas for performance in the coming year. Instead of the core/satellite equity approach, we will generate enhanced alpha of 50 to 75 basis points with an enhanced index fund that has a tracking error of 1%." Mr. Menco said the fund can get an enhanced return of 50 to 75 basis points on its bond investments with a tracking error of just 10 basis points.
"It's a very attractive information ratio we won't get with active investments," he said. "We'll combine this strategy with active mandates where the tracking error is much higher."
Main selling point
High information ratios - how much value is added per unit of risk - is a main selling point for global enhanced indexing.
Mr. Emmett said that for J.P. Morgan's enhanced EAFE strategy, for the year ended Nov. 30, the firm returned 158 basis points over EAFE with a tracking error of 79 basis points, for an information ratio of 2.
Henderson has had 67 basis points in excess return on its U.K. enhanced equity index strategy since 1997 with 34 basis points of tracking error, which also produced an information ratio of 2, according to Mr. Fraser.
"I won't say that's maintainable," said Mr. Fraser, "but I feel confident we can deliver 50 basis points (of excess return) per annum," he declared.
Martin Noll, head of investment manager research for Europe with Watson Wyatt Worldwide in London, said he is seeing much more interest in enhanced indexing from U.K. and European clients.
"There are higher information ratio approaches" that can be used for enhanced indexing, he said. "Different managers have different approaches. The better enhanced index managers have a variety of structures to add value." He added the use of performance-related fees is important.
"Higher information ratios give outperformance and then the performance related fees are attractive," said Mr. Noll.
At State Street Global Advisors, London, Chief Investment Officer Chris Woods said the U.K. division of the giant money manager, the second largest manager of indexed assets worldwide, now has $3.2 billion in enhanced equity index assets under management. The strategies used by SSgA include "looking to exploit stock price anomalies, arbitrage opportunities including M&A arbitrage, and quantitative forecasts based on value and sentiment indicators," Mr. Woods said.
Ronald Kahn, managing director of Barclays Global Investors, San Francisco, the world's largest indexer, pointed out that during the 1990s, many active EAFE managers could easily beat the benchmark by underweighting Japan and investing in technology stocks. Now, with EAFE's revision, Japan is a smaller segment of the index, and many technology stocks not in the EAFE index before are in it now.
"Now, the only way money managers will outperform EAFE is by stock picking," he said. That's what BGI, which is also the largest manager of enhanced index funds with about $60.6 billion under management, does with its enhanced index strategies, he added.