Enhanced index strategies notched solid gains in the second half of 2002, continuing a trend that started nearly two years ago with investors seeking incremental increases over market indexes without taking on much additional risk.
Worldwide indexed assets - both passive and enhanced - under management by the 60 institutional money managers surveyed by Pensions & Investments held steady at $2.4 trillion at the end of last year. When adjusted for market results, however, worldwide indexed assets were up about 7% since June 30, despite market volatility, economic uncertainty and the threat of war.
Institutional tax-exempt indexed assets inched up to $1.42 trillion as of Dec. 31 from $1.41 trillion on June 30; that's a solid 9% increase, when adjusted for market results. Institutional assets represent about 59% of the $2.4 trillion in worldwide indexed assets managed by the 60 managers surveyed by P&I.
Market volatility has been the defining characteristic of global market indexes since 2000. The S&P 500 stock index was down 10.3% during the second half of 2002, while the Salomon Broad Bond index gained 6.3% for the same period. On the international side, the Morgan Stanley Capital International Europe Australasia Far East Index was down 14.5% for the second half of 2002, while the J.P. Morgan Non-U.S. Government Bond index gained 9.1%.
Volatile and stumbling stock markets have caused many plan sponsors to seek lower-risk investments that at least track major market indexes, according to industry sources. That has resulted in additional assets being allocated to enhanced strategies, a trend that index managers expect to continue.
Enhanced up 9%
Enhanced domestic equity indexed assets were up by a market-adjusted 9% during the second half of 2002, to $227.1 billion. Enhanced non-U.S. equity indexed assets grew by an impressive market-adjusted 27%, to $24.1 billion at the end of 2002. Enhanced domestic fixed-income indexed assets increased by a market-adjusted 12% in the second half to $70 billion, although enhanced non-U.S. fixed-income indexed assets dropped by a market-adjusted 16%, to $4.2 billion.
Enhanced indexed assets comprise 23% of the institutional tax-exempt indexed assets tracked by P&I, but industry experts expect that percentage to increase as plan sponsors seek to stabilize their investment portfolios while dealing with funding difficulties.
An internal analysis by INVESCO, Atlanta, of external active and enhanced indexed managers in the Plan Sponsor Network database contradicts the conventional wisdom that higher risk active managers generate proportionately higher returns. David Wonn, product manager for INVESCO's structured products group in Boston, studied 600 managers that were benchmarked to the S&P 500 over a 10-year period ended June 30. Managers were broken down into three levels. Enhanced or structured strategies with tracking errors ranging from 0-2; traditional asset managers with tracking errors in the 2-8 range, and high risk managers with tracking errors over 8. The INVESCO analysis shows that managers with low tracking errors (below 2%) added more value to their portfolios than managers with higher tracking errors. Enhanced index managers tend to have low tracking errors, while traditional managers have higher tracking errors, in the 2% to 7% range, he said. The study showed that managers with up to 2% tracking error added a median 83 basis points in value, while managers with tracking errors from 2% to 7% had added an average of 44 basis points in value. "When we look at traditional managers - those in the tracking error range of 2% through 7% - we see a higher proportion of index under-performers," he said. "The cream of the active management crop appears to be in the region of low tracking error approaches."
Not conventional wisdom
What the study shows about risk and reward in stocks is "far from conventional wisdom... We are saying that enhanced strategies are lower risk, relative to the benchmark, while delivering nearly twice the return of active management over a 10-year period," Mr. Wonn said. "There is a growing interest and substantial allocation to enhanced index equity strategies. We are seeing interest from both sides of the table. People in traditional passive indexes ... for very little risk can get access to the return of traditional active management while some investors want to dial down their active management. They can't afford the tremendous tracking error, given their funded status, and are looking for more consistency."
Barclays Global Investors, San Francisco, retained its position atop the indexing world with $743.5 billion in worldwide indexed assets under management, of which $407.3 billion was institutional tax exempt. BGI was followed by State Street Global Advisors Inc., Boston, with $650.8 billion in worldwide indexed assets, of which $381.7 billion was institutional tax exempt.
As in previous P&I surveys, manager turnover plays a part in arriving at index totals. BlackRock Inc., New York, is included in the survey for the first time, adding more than $8 billion in institutional tax-exempt assets to the universe. In addition, Smith Breeden Associates, Chapel Hill, N.C., for the first time reported its $1 billion institutional tax-exempt indexed assets. And First Madison Advisors, Madison, Wis., shut down its index management capabilities, removing about $123 million from the institutional tax-exempt indexed total.
The top 10
The 10 largest index fund managers account for approximately 82% of the U.S. institutional tax-exempt assets in P&I's survey.
The composition of the top 10 list, however, is about to change. One transaction that occurred after the survey period will have a significant impact on future surveys: Northern Trust Corp., Chicago, completed its acquisition of Frankfurt-based Deutsche Bank AG's global passive and enhanced index asset management business in February. Each company was already a major player in the indexed asset management business and is listed separately in the current survey. Their combined worldwide assets of $164.1 billion would have propelled Northern into a solid fourth place. Their combined institutional tax-exempt indexed assets would have been more than $108 billion for the same period, which would have made Northern the third-largest manager in that category.
Terry Toth, executive vice president at Northern Trust, said he expects 85% to 90% of Deutsche's customer base and assets, or $68 billion to $78 billion, to move over to Northern, a process that should be completed over the next three months.
Mr. Toth said Deutsche's international capabilities were one of the "keys" to the acquisition. Deutsche reported about $5.5 billion in worldwide non-U.S. fixed-income indexed assets under management as of Dec. 31, none institutional tax-exempt. Deutsche had about $10.7 billion in non-U.S. institutional tax-exempt equity indexed assets under management for the same period.
The Deutsche acquisition "will broaden our international capabilities and will give us more scale in the United States," said Mr. Toth. Deutsche's $797 million in enhanced U.S. equity indexed assets and $430 million in enhanced non-U.S. indexed equities were also attractive to Northern. "It (enhanced indexing) is an important market in the United States, and one in which we expect to see a lot of growth, particularly in Europe."
In all, the acquisition of Deutsche's passive and enhanced index capacities will result in nearly 170 new clients at Northern, Mr. Toth said. Northern officials wanted the acquisition to put the company closer in size to BGI and SSgA, giving indexing clients access to "a (larger) third alternative."
Flat growth, mostly
Most managers of indexed assets experienced relatively flat asset growth during the six months ended Dec. 31. A handful did show healthy increases in institutional tax-exempt assets, including Aeltus Investment Management, Hartford, Conn.; AllianceBernstein Institutional Investment Management, New York; DSI International Management Inc., Norwalk, Conn.; Evergreen Investments, Boston; Mellon Bond Associates, Pittsburgh; and SSgA.
Institutional tax-exempt indexed assets at SSgA increased by 22% to $382 billion during the second half of 2002, primarily because it more than doubled its domestic fixed-income indexed assets to $195.7 billion, up from $94 billion June 30.
J. Victor Thompson, principal and director of global fixed income at SSgA, said there was growth in most of SSgA's fixed-income index strategies, but a substantial portion of the growth was cash. He said investors who are uncertain about the financial markets have been parking some cash for stability in volatile markets.
Aside from the "flight to quality" in short-term investments, he said, SSgA saw growth in both its passive and enhanced index strategies.
"We've experienced growth in both passive and enhanced indexing," he said. "The driver largely was the underperformance of active managers worldwide who have had a hard time beating the index. A 200- to 300-basis-point underperformance wasn't hard to find last year. Boards and clients started asking why, with the uncertainty and troubled times. A lot of them looked around and saw that the fees for active managers were six or seven times that of passive management, and all they were getting was volatile results," said Mr. Thompson. Much of the inflow to indexing at SSgA was from public funds or funds outsourcing to external managers. "Public funds were definitely a huge factor," he said.
Additional findings from the P&I survey include:
* U.S. institutional tax-exempt indexed equities were up only slightly - 1% on a market-adjusted basis - in the second half of the year, while domestic fixed income indexed assets were up a market-adjusted 27%. Indexed international equities declined a market-adjusted 17% in the second half.
* The 60 managers surveyed reported $671.1 billion in defined benefit assets, or about 47% of the total U.S. institutional tax-exempt indexed assets. Defined contribution plan assets totaled about $296 billion, or 21% of institutional tax exempt indexed assets.
* Mutual funds represented about 42% of the total $949 billion in U.S.-based indexed assets in the second half of 2002. Domestic equity mutual funds totaled $302.5 billion as of Dec. 31, up a market-adjusted 4% from June 30.
* Total worldwide international indexed bonds, by far the smallest asset class in the survey, grew to $131 billion at year's end, up a market adjusted 25% from June 30.