Control, cost behind IBM’s in-house index strategy

WHITE PLAINS, N.Y. — Ask Jay Vivian why IBM believes in indexing, and he'll give you two reasons: cost and control.

"We can do as good a job as an outside firm at a lower cost and at the same time maintain total control in terms of custody, visibility, guidelines and risk controls. We can have a tighter tracking error," said Mr. Vivian, assistant treasurer/managing director, IBM Retirement Funds, in an interview.

Nearly one-third of the $42 billion defined benefit assets of International Business Machines Corp. are indexed equities, all managed by an in-house staff of six.

In addition to managing $12.6 billion for the U.S pension plan, the in-house staff also runs a total of $2 billion in indexed equities for four subsidiary retirement plans: IBM Netherlands, IBM Germany, IBM Switzerland and IBM Canada. Mr. Vivian wouldn't disclose sizes of the individual funds, saying only they range from $1.3 billion to $8.3 billion.

The five portfolios are each managed as stand-alone separate accounts, which allows for better control and better reporting. Mr. Vivian noted that each of the four subsidiary plans hired the U.S. IBM staff to manage its passive equities after conducting a manager search.

Currently IBM is running around $10.4 billion in U.S. equities against the Russell 1000 index benchmark; $3.1 billion in international equities against the Morgan Stanley Capital International Europe Australasia Far East plus Canada; and $500 million in indexed real estate investment trusts (for the U.S. plan only) against the Morgan Stanley REIT index.

In 2003, IBM's domestic passive equities "were on benchmark," up 29.9%, he said; its non-U.S. passive equities rose 40.1%, beating the MSCI EAFE+Canada, which gained 39.4%; and the REIT portfolio also matched its benchmark, posting -0.1%.

IBM's $22 billion 401(k) plan is all indexed, but managed by outside firms because the daily trading in the different funds results in large cash flows, which would require more complex "machinery" than IBM has. "We rebalance (the indexed equities in the defined benefit plan) around once a month, which we can handle because it doesn't involve moving as much cash around," explained Mr. Vivian.

The U.S. plan is about in 68% equities, which includes private equity, public and private real estate) and about 32% in bonds. Within the equity allocation, about 75% is indexed; in fixed income, about 20% is indexed.

Two years ago, IBM increased the indexed equity portion of its U.S. plan to 75% of equities from 50%. "We're biased toward indexing. The markets have gotten more efficient. If it were easier to find active managers that generate more excess return we might switch it again but those fees aren't zero," Mr. Vivian noted.

"You might find active managers charging really low fees of around 30 to 40 basis points. If it's a small-cap or emerging market manager, you might pay 70 to 110 basis points. We can run the indexed portfolio for under one basis point. For active management, we need to be sure they're generating 200 basis points if we're going to have to pay 100 basis points. It's great if we're assured they can do it, but managers don't always make 200 basis points over the benchmark. Sometimes they just make benchmark."

IBM doesn't currently use any enhanced index strategies. "We've done it in the past, but we don't believe it's worth the extra effort. It's hard for them to consistently outperform," Mr. Vivian said.

The plan does use active managers for small-cap equity mandates, a change instituted about five years ago. The fund used to run the indexed portfolio against the Russell 3000 index. "Small cap is good for active management, and it has done well," observed Mr. Vivian. He declined to name managers, citing company policy.

The U.S. plan doesn't use any outside managers for equity indexing, but fixed income is another story.

"There are so many more securities in the fixed income Lehman Aggregate and Lehman Universal indexes (that) it would be too difficult to manage in-house," Mr. Vivian said. The non-U.S. plans do use some outside indexers for equities, but Mr. Vivian would not elaborate.

While the IBM in-house staff has no plans now to expand into running money for outside investors, Mr. Vivian does expect to manage passive assets for some of the other 26 IBM subsidiary retirement plans.