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Special Report: Index Managers

Passive investing continues to captivate global audience

Callan’s Jay V. Kloepfer cited passive as ‘a key element to all of our clients’ portfolios.’

Global indexed assets up 13% in a world demanding lower costs

Worldwide indexed assets under management rose 13% during the year ended June 30, with assets growing to $13.37 trillion from $11.83 trillion the previous year, according to Pensions & Investments' annual survey of managers of indexed assets.

"From our perspective, passive is clearly a key element to all of our clients' portfolios. It has been and it continues to be," said Jay V. Kloepfer, executive vice president and director of capital markets research at Callan LLC in San Francisco.

Equities continued to hold the highest share of passively managed assets in 2018. As of June 30, $6.42 trillion was managed in U.S. equity, a 16% increase from the previous year's $5.53 trillion. Assets managed in international equity rose 7.7% to $2.67 trillion and global equities increased 6.2% to $1.23 trillion.

For the one-year period ended June 30, the S&P 500 index returned 14.37%; the MSCI All Country World index, 10.73%; and the MSCI All Country World index ex-U.S., 7.28%.

Mr. Kloepfer said the low cost of passive funds and the inability of some managers to significantly outperform indexes could cause dissatisfaction in some spaces, such as active domestic large cap, but he sees opportunities for active managers in international equities, particularly in emerging markets and international small-cap.

"The amount of research to work effectively in those areas is daunting. Most of those markets feature a large number of stocks and very few have coverage. That's where we think active management has the real potential to shine," he said.

Global/international fixed-income assets under indexed management saw the largest percentage in growth in 2018, rising 18.1% to $1.08 trillion, while domestic fixed income rose 13.5% to $1.76 trillion.

The Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned 1.36% for the year ended June 30 and the Bloomberg Barclays U.S. Aggregate Bond index returned -0.4% for the period.

Mr. Kloepfer said the possibility of future interest rate increases and potential uncertainty in bond markets could provide an asset-gathering opportunity for active fixed-income managers. "That would be one area where I would expect there to be less of an advance as a relative share (of passively managed assets). Most of our investors, and we agree, want somebody active at the helm," he said.

Passive outperformance

However, active managers of intermediate-term fixed income were the only category to outperform their passive peers during the year ended June 30, according to a report by Morningstar Inc.

Morningstar's "Active/Passive Barometer" measures the net-of-fees performance of active managers relative to a composite of passive funds in the same Morningstar category. The report said 70.9% of active intermediate-term bond managers outperformed comparable passive funds for the year ended June 30, while the majority of active managers in all of the other measured categories underperformed.

Ben Johnson, director of global ETF research at Morningstar in Chicago, said measuring active funds against passively managed peers in a way that factors in fees and other costs associated with the realities of managing an index portfolio "is more meaningful and more representative of the decisions that investors are presented with. At the end of the day, we think it better reflects the opportunity set that is available to investors."

The Morningstar report said 48.1% of active corporate bond managers outperformed their passive peers on a net-of-fees basis during the one-year period.

Among equities, active managers in Morningstar's diversified emerging markets category had the best results, with 47.7% outperforming passively managed funds.

In global and international equities, 44.5% of active managers in Morningstar's large-cap world stock category outperformed, 40.7% in foreign large-cap value, 30.1% in foreign large-cap blend, 26.7% in foreign small/midcap blend, and only 25% of active managers in the Europe stock category outperformed their passive peers for the year ended June 30.

In U.S. equities, 44.1% of active domestic large-cap growth managers outperformed, 41.5% in the domestic midcap growth category, 41% in domestic small-cap growth, 36.2% in domestic large-cap blend, 34.8% in domestic large-cap value, 29.6% in domestic midcap value, 28.6% in small-cap value and 23.5% in the domestic midcap blend category. U.S. small-cap blend had the highest rate of underperformance, with only 23.1% of active managers outperforming their passive peers during the one-year period.

"One of the long-term signals is that active managers have a hard time adding value. In particular, they have a harder time adding value the higher the fees they charge. It's just basically the math. That said, long-term success rates can vary significantly over categories," Mr. Johnson said.

For the 10-year period ended June 30, 92.9% of active foreign small/midcap blend managers outperformed their passive peers, 62.5% of corporate bond managers, and 51.7% of active managers in the Europe stock category beat comparable indexed strategies. Meanwhile active managers in all of the other Morningstar categories underperformed, particularly in U.S. equity strategies, where all categories saw less than 30% of active managers outperforming.

Tax-exempt AUM rises 10.9%

Passively managed U.S. institutional tax-exempt assets were up 10.9% in 2018, rising to $4.27 trillion. Institutional investors had $2.75 trillion in passive domestic equity, a 13.6% increase; $703.5 billion in domestic fixed income, a 9.7% increase; a 5% rise in international equity to $468.1 billion; a 1.1% increase to $310.3 billion in global equity; and $15.5 billion in global/international fixed income as of June 30, a 1.8% increase over the previous year.

"The biggest increases that we've seen in passive have been in the most efficient markets, in U.S. equities. My expectation is that we'll start to see a little bit of a reversal there as active management is more valued because of greater diversification," said Celia Dallas, Arlington, Va.-based chief investment strategist at Cambridge Associates LLC.

Ms. Dallas said the potential for more dispersion in returns as the three major central banks move to quantitative tightening from quantitative easing may set the stage for skilled active managers to generate more alpha relative to index funds.

"You're seeing an increase of movement of capital into private investments and niche strategies that have greater alpha potential," she said.

The expansion of passive investment options at increasingly low fees, along with the difficulties most managers have had in keeping up with indexes in this bull market, has put some downward pressure on active management fees, Ms. Dallas said.

"The environment is changing and managers understand that. Investors are increasingly discriminating in terms of wanting to make sure that every dollar of fees that you pay counts. And if you're able to negotiate lower fees, that's alpha that you get to keep," she said.

DC assets outpace DB

Passively managed U.S. defined contribution assets jumped 10.4% to $2.15 trillion over the year, while U.S. defined benefit plan assets under indexed management increased 0.2% to $1.12 trillion, and passively managed assets for U.S.-based foundations and endowments rose 14.8% to $139.1 billion. Assets managed for non-U.S. retirement plans increased 5.4% to $1.54 trillion.

Exchange-traded fund/exchange-traded note assets in P&I's universe increased 19.2% to $3.79 trillion from $3.18 trillion a year earlier.

BlackRock (BLK) Inc. (BLK), New York, once again topped P&I's list of managers with a 12.8% increase to $4.15 trillion of indexed assets under management as of June 30, but the gap with Vanguard Group Inc. narrowed further.

BlackRock's passively managed U.S. institutional tax-exempt assets rose 10.1% to $1.086 trillion in 2018 from $985.8 billion one year earlier, falling slightly behind Vanguard for the first time since BlackRock first led the rankings in 2012. U.S. DC indexed assets under management rose 15.5% to $600.1 billion for BlackRock, U.S. DB assets were up 2.2% to $433.9 billion, and passively managed assets for U.S.-based endowments and foundations rose 9.7% to $21.1 billion.

BlackRock's passively managed non-U.S. retirement assets rose 6.5% to $738.6 billion, nearly twice as much as the second-largest manager.

Malvern, Pa.-based Vanguard Group was the second-largest manager of total indexed assets on P&I's list, with a 16.8% increase in the year to $3.86 trillion.

Rodney Comegys, principal and head of Vanguard's equity index group, said growth has been "a multiyear, fairly consistent trend. Acceptance and default allocation to target-date funds has been the most macro trend. They give a consistent investor experience. They follow the market. They're low cost. And we've benefited by having the most target-date funds that are index assets."

According to P&I's historical data, Vanguard's indexed assets under management have risen more than eightfold from $474.5 billion as of June 30, 2006.

Vanguard is the largest U.S. defined contribution manager on P&I's list, with $865.3 billion in indexed DC assets as of June 30, a 12.55% increase over the previous year. Mutual funds, which account for more than 68% of Vanguard's total indexed assets, rose 15.9% to $2.62 trillion in the year ended June 30.

In addition to low fees, Mr. Comegys said a significant part of the firm's growth has come from building products that give investors broad-based access to different market segments. "That's the utility of Vanguard products, or ETFs, or index products in general. As you need exposure, they are a great way to build that," he said.

Vanguard's ETF/ETN assets increased 21% to $885.5 billion as of June 30. BlackRock remains the largest ETF provider, with AUM growing 16.3% to $1.78 trillion.

Vanguard's passively managed U.S. institutional tax-exempt assets rose 15.7% to $1.09 trillion in 2018. U.S. DB assets dropped 11.9% to $29.7 billion, while passively managed assets for U.S.-based endowments and foundations saw Vanguard's largest percentage increase, rising 39.7% to $27.6 billion.

State Street Global Advisors, Boston, was in third place on the overall list of top managers, with a 5.41% rise in passively managed assets to $2.04 trillion as of June 30.

State Street topped the list of indexed assets managed for non-affiliated insurance companies, with $117.4 billion as of June 30; for sovereign wealth funds, $81.1 billion; U.S.-based foundations and endowments, $61.4 billion; and central banks, $48.9 billion.