Market gains, big demand for indexing fuel 24% asset increase

Worldwide internally managed index assets rose to $8.97 trillion in the year ended June 30, a $1.74 trillion increase, according to Pensions & Investments' annual survey of managers of indexed assets.

This 24.1% surge surpassed the previous year, when assets increased 18.4%.

“On aggregate, the trend is inexorable,” said Jamie Farmer, New York-based managing director, index investment strategy at S&P Dow Jones Indices LLC. “Institutional investors are being drawn toward the passive space on the basis of performance and on the basis of fees.”

BlackRock Inc., New York, led the pack for the fifth consecutive year with $2.825 trillion of indexed assets, a 23% gain from a year earlier. A 33% increase moved Malvern, Pa.-based Vanguard Group Inc. up to second place on P&I's list with $2.079 trillion, passing State Street Global Advisors, Boston, which dropped to third place despite seeing a 17% increase that raised their total to $1.972 trillion.

A 22% rise to $471.5 billion kept Northern Trust Asset Management, Chicago, in fourth place for the ninth consecutive year; followed by New York-based Bank of New York Mellon, which spent an eighth year in fifth place with a 24% increase to $355.6 billion.

“I would say the significant piece of growth is down to market movements,” said Jane Welsh, London-based senior investment consultant and head of the indexation research team at Towers Watson & Co. “Most of our clients have already got passive management as a big piece of what they do already. If you're seeing AUM growth, market movements will be a significant contributor.”

For the year ended June 30, the Russell 3000 index returned 25.2%; the Morgan Stanley Capital International World index, 24.8%; and the Morgan Stanley Capital International EAFE index returned 24.4%.

Even in a year of strong returns, index management remains an attractive option when many active managers don't provide alpha relative to fees, said Johnny Wu, New York-based managing director and head of equities and fund structured markets sales, Americas for Barclays. “You're going to see active management challenged to show value. A lot of managers have underperformed,” Mr. Wu said.

Most active managers underperformed their one-year domestic equity benchmarks as of June 30, according to the midyear S&P Indices Versus Active Funds U.S. Scorecard. Measured against the S&P 500, 59.78% of active large-cap managers underperformed the broad index, while 57.84% of active midcap managers failed to beat the S&P MidCap 400 and 72.79% of active small-cap managers underperformed the S&P SmallCap 600. A rolling five-year analysis shows that 73.56% of active managers across all domestic equity market capitalizations underperformed the composite benchmark.

Data from S&P Dow Jones Indices show 74.86% of active international equity managers underperformed relative to the S&P 700 benchmark for international funds as of June 30, while 74.23% underperformed over the five-year period. Measured against the S&P Global 1200, 70% of active global equity managers underperformed for the year and 70.26% underperformed over five years.

Among the 57 managers surveyed, $4.201 trillion was managed in U.S. equity, up 27.11% from the 58 managers that responded in the previous survey; assets managed in international equity rose 29.57% to $2.042 trillion; and $659.4 billion was managed in global equity, up 32.6%.

Vanguard's domestic equity assets under management increased 36.2% to $1.269 trillion and international equity assets rose 36.6% to $459.1 billion.

Geode Capital Management was in sixth place on P&I's list for a fourth consecutive year, with a 28.1% increase to $187 billion of indexed assets under management. Geode saw a 35.7% increase to $162.3 billion in domestic equity and a 56.7% increase to $21.8 billion in international equity assets.

Assets fell 34.6% to $43.4 billion for T. Rowe Price, the only manager in the top 20 to see total assets decrease as of June 30. Assets managed by T. Rowe Price in domestic equity fell 39.4% to $37 billion.

“Even in bull markets, clients are still buying low (volatility) strategies,” said Amy Schioldager, BlackRock's San Francisco-based senior managing director and global head of beta strategies.

Ms. Schioldager said factor-based passive equity strategies — often referred to as smart beta — have attracted assets from investor segments that have not traditionally been big buyers of index funds, such as insurance companies and sovereign investors. Smart beta strategies are also appealing for retirement plans that are at or near full funding, a shift that BlackRock attributes to more defensive investors seeing smart beta as a way to protect their downside and compensate for low bond yields. “They don't need the upside returns but still want to participate in the equity market. You don't want to threaten the funding status of the plan,” she said.

“Factor-based indices are the kind of thing that you would have paid an active manager 10 times the fees for,” said Mr. Farmer of S&P Dow Jones Indices. “The ability to bring that toolkit to investors has led to much greater expansion in passive investment overall.”

U.S. retirement plan, foundation and endowment assets under indexed management by the top 25 managers rose 19.04% to $2.696 trillion in the year ended June 30. The order of the top three managers remains unchanged from the previous year. BlackRock topped the list at $771.2 billion, a 20.4% increase, followed by SSgA's 19.8% rise to $617.8 billion and Vanguard's 27.4% increase to $530.3 billion.

Passively managed U.S. defined contribution assets grew 26.9% to $1.479 trillion, while U.S. defined benefit assets rose 10.8% to $1.112 trillion. BlackRock topped the list of defined benefit managers with $376.8 billion in indexed assets under management, while Vanguard managed the most defined contribution assets with $479.2 billion under indexed management.

S&P Dow Jones Indices estimates $2.58 trillion was directly linked to their indexes as of Dec. 31, according to their annual survey of indexed assets, an estimated increase of 30% over year-end 2012.

Among the 57 managers surveyed, $1.024 trillion was managed in domestic fixed income as of June 30, up 8.39% from the previous year, and assets in global and international fixed income rose 18.43% to $944.3 billion.

The Citigroup Non-U.S. World Government Bond index returned 6.85% for the year and the Barclays Capital U.S. Government/Credit Index returned 4.3%.

Despite the low bond returns, Vanguard reported a 16.8% increase in domestic fixed income and 30.5% increase in international and global fixed income to $296.7 billion and $54.2 billion, respectively.

Barclays' Mr. Wu sees the current fiscal environment constraining retirement plan moves into fixed income. “After the financial crisis, the underfunding of pension plans hasn't allowed them to move to (liability-driven investing). The challenge is that interest rates are too low to make a substantial effort to do it right now.”

Mr. Wu said fixed-income managers are expanding the market of liquid index products to generate greater inflows. “Everybody is scrambling to offer more fixed-income ETPs. That's the next holy grail. You have to go out and on the margin be able to buy the bonds to replicate the index. Exchange-traded products are better, faster, cheaper.”

Assets for the top 10 managers of exchange-traded funds/exchange-traded notes increased 29.88% as of June 30, to $1.976 trillion. The top three remained the same for the fifth consecutive year. BlackRock led the group with $993.8 billion, followed by SSgA with $412.6 billion and Vanguard with $381.1 billion.

U.S. institutional tax-exempt indexed assets rose 16.37% to $3.156 trillion as of June 30. BlackRock topped the group again with $795 billion, a 19.71% increase over the previous year, followed by SSgA with a 12.99% increase to $690.6 billion, despite SSgA's domestic fixed-income assets dropping 2.8% for the year.

“Institutions are looking for returns wherever they can,” said Rolf Agather, global managing director, index research and innovation at Russell Investments in Seattle. Indexes are a tool that well-informed investors can use to gain broader diversification, he said, including exposure to volatile investments like currencies and foreign markets. “It is giving the investor the opportunity to take more control over their portfolios. If the goal is to achieve broad exposure, you can get that at fairly low cost from an index.”

However, Mr. Agather cautions that index investing is not an effortless process and he highlights the need for investors to “understand how to use these products and how they might fit into a portfolio. Pay more attention to the methodology and how the index is being constructed.”

William J. Donahue, Boston-based managing director, asset management practice at PricewaterhouseCoopers LLP, also highlighted the importance of index education and noted that the relationship between smart beta index funds and markets can lead some investors to inaccurately perceive the reality of some passive index products.

“People might presume that smart beta indices are smarter or that they can adapt for changing market conditions, but most smart indices may not be able to shift without changing their investment mandate.”

A research forecast from PwC sees global passive investments reaching $22.7 trillion by 2020. Mr. Donahue said the increase will be “as much flow-driven as performance. We expect a continued focus from people looking for products that they understand, that are relatively simple.”