(May-2002) No longer riding the benchmark?

The substantial growth in passive global equity management over the past decade has been nibbling away at the domination active management has had in global equities portfolios.

Partly to blame for this has been the difficulty active managers have experienced in beating their index, as well as growing investor sophistication in the use of risk budgets and cost-effective investment management.

More recently, however, global market conditions have shifted substantially with the collapse of the technology, media and telecommunications (TMT) sectors, mixed corporate profit performances and signs of recession in major global economies. And, such an investment environment has pushed the emphasis towards fundamental analysis.

According to Towers Perrin, active managers have, on average, added value over the benchmark in 16 of the 24 months to December 2001. In the 10 years to December 2001, active managers outperformed the benchmark in down markets in 71 per cent of all months.

“We do not advocate trying to market-time the appropriate allocation between active and passive management. However, the conditions that led to market-driven returns of around 20 per cent per annum for global equities through the late 1990s no longer prevail,” Towers Perrin research head Chris Durack says.

“There are widely held expectations for a relatively low return environment for global equities markets going forward. Excess returns that active managers can potentially generate are greater as a proportion of the total market return, which suggests there are stronger arguments in favour of active management in global equities than there were in the late 1990s,” he adds.

The relative performance of active management typically tends to vary over time due to the prevailing market environment.

The late 1990s were generally characterised by ‘narrow market’ conditions — markets that are momentum-driven and where performance is largely dictated by a relatively small group of stocks or sectors. This type of market does not lend itself well to active management because strong fundamental analysis is not rewarded unless managers invest in the few choice sectors.

Instead, active managers tend to perform better in ‘broad market’ conditions — markets where a variety of companies and sectors drive overall market performance. In this type of market, a well-resourced and capable active manager is more likely to generate outperformance of a benchmark because there are numerous opportunities to be identified and exploited through superior fundamental analysis.

Certainly, a reliance on active asset management of all asset classes has paid off for some super funds, especially the Retail Employees Superannuation Trust (REST), which tops Super Review’s TOP 300 list this year with the best crediting rates for the year to end June 2001.

But some asset consultants doubt that active management can add value in all classes. As Super Review reported recently, Mercer Investment Consulting (MIC) will stop researching active Australian fixed interest managers.

Christopher Andrews, head of MIC, says this is because his group does not believe managers that focus on macro-economic forecasting and future interest levels can demonstrate consistent ability to add value in fixed interest.

Of course, various other asset consultants disagree, including Frank Russell, pointing out that more research will be needed as the market increasingly looks to corporate issues, as government debt shrinks.

Mercer now plans to focus its research efforts on the enhanced passive approach to Australian fixed interest investing, which aims to exploit a wide range of security-specific pricing anomalies to generate modest but consistent levels of excess return relative to benchmark.

After a period of exclusive use of active management in international equities, followed by the rapid rise of indexing, enhanced products are the latest incarnation. Enhanced index funds now enjoy a high profile, particularly as a result of the volatility in active management in recent years. Super funds view them as more than a marketing idea. The attraction is that they get modest amounts of excess return while closely tracking the characteristics of a benchmark.

Kenneth Yip, managing director and global head of research at Deutsche Asset Management’s (DAM) New York research establishment, describes this advance in passive investment management as “an evolutionary leap forward” and bills it as “the next generation of passive investment management”.

One fund that has embraced enhanced indexing for major listed asset classes is Westscheme. CEO Howard Rosario says the advantages of using these managers include that they adopt a style neutral approach, rather than focusing on either growth or value styles.

He adds that enhanced indexed managers also have tight risk controls that limit the deviations from the benchmarks. This reduces the risk of performance substantially different from that of the index.

By spreading their positions over a wide range of stocks and by not focusing on any particular investment style, enhanced indexed managers aim to produce consistent outperformance. They often use quantitative techniques.

Ken Marshman, managing director of JANA Investment Advisers, adds: “Enhanced passive is attractive in some cases because of the different approaches taken by managers to add small amounts of value compared to fully fledged active managers.”

He notes that the risk/return equation can be quite different for small bets.

“Relative to pure passive this is an advantage. Further, enhanced passive provides the opportunity, although only rarely, of taking advantage of a major discrepancy in markets, whether by a change in index or by a large one-off flow of funds.”

In addition to controlling investment risk in a way that active management can’t, enhanced strategies also offer critical control of business risk.

For many funds that are constantly being compared, the business risk associated with having an active manager significantly underperform is greater than the foregone performance. Many funds don’t want positions that are too different to index, so if they underperform, they can blame it on the index and not because the manager blew-up. This is easier to explain to members.

There are many ways to enhance, with the approach largely depending on which end of the risk spectrum the manager comes from.

The different managers involved in enhanced indexing offer strategies boasting targeted returns ranging from 50 to 250 basis points for equity portfolios.

Two main approaches can be identified. First, the traditional quant index manager uses screening techniques across the market to identify companies that generally have some sort of value character, growth character or momentum character. The stock picking is then based on varying degrees of valuations, momentum and earnings expectations. Every model has a nuance that makes it a little bit different.

The second major approach is from active managers that use quantitative techniques and models to control risk across countries and sectors, and then build stock positions into the process. Building on analysts, they remove the incidental risk.

But managing director of Frontier Investment Consulting, Fiona Trafford-Walker, says enhanced indexing is no “free lunch”.

“Some enhanced indexing is actually very low risk active and investors need to carefully consider where the value is coming from and how that affects their overall portfolio,” she says.

“We typically find that clients that are happy taking a little benchmark risk will look at these products, but those that want a pure passive structure will stick with passive managers who might make use of minor enhancements.

“We also see that, for many clients, the allocations to active and passive (or enhanced passive) are based on issues of risk control against industry standard benchmarks, the ability of active managers to consistently add value, the fee trade-off and tax implications of more active strategies.”

So is there still a debate between active and passive investment approaches?

DAM describes competition between the two approaches as a “myth”. Head of retail Bruce Murphy says the debate about the respective merits of active versus passive indexing has obscured the fact that the two are not competing styles.

“The real issue is how fund managers add value, by how much and what risks they take. The trend to active resulted because over the last 10 years the median active manager beat the benchmark. This means there are some skilled managers, but there are also probably some market inefficiencies in place.”

But Towers Perrin’s Durack notes: “Despite the cyclical nature of the relative performance of active managers, over the longer term, skilled managers should add value in global equities. Also active managers have potential to reduce risk through lower volatility than the benchmark and reduce losses in falling markets. However, there will be periods when active management will not provide the best returns in global equities.”

Durack believes that with the magnitude of decline in inflation and interest rates during the 1990s unlikely to be repeated, equities returns are expected to be considerably lower than during the 1990s.

“In such a market environment, equities indices cannot be solely relied upon for strong returns and the potential outperformance that can be provided by active managers is much more significant to the total return,” he says.

He adds that passive management can still provide benefits in the form of simplicity of investment, diversification, lower costs and low performance deviation versus benchmark.

“Thus, any decision on the allocation between active and passive global equities management needs to be made within the context of an overall risk budget.”