Index based Investment

SURVEY - INDEX-BASED INVESTING: An industry enjoying life in the fast track A once derided form of investment management has gained acceptance, and achieved enormous growth, in recent years, reports Simon Targett
Financial Times; Jul 18, 2001
By SIMON TARGETT

It is hard to imagine that index-tracking investment started 30 years ago this month with a mere Dollars 6m slug of money from a bag manufacturer.

Today, index-tracking specialists run Dollars 2,300bn of assets around the world, and there is a general expectation that this figure will grow dramatically over the next decade, as pension funds and individual investors buy into the idea that index funds make sense. But, if index funds have an established place in the investment world, they were no overnight success. After 10 years, only Dollars 10bn was invested in such funds and after 20 years, just Dollars 270bn: in other words, it is only in the last 10 years that index-tracking has really taken off, growing nearly ten-fold.

Why this slow rate of growth?

This is a question that has baffled the architects of index-tracking investment: the band, or what some have called the "constellation", of fund managers, computer whiz-kids and Nobel Prize winning academics who dared to think differently. It is not that the science of index-tracking has become significantly more sophisticated in the past 10 years. Right from the beginning, index trackers tried to match a benchmark index created by index manufacturers notably Standard & Poor's. Although today's computers are more powerful and today's tracking techniques more refined, the underpinning science rests on the brilliant work of some star American academics in the 1950s and 1960s: Harry Markowitz, William Sharpe, Eugene Fama. In sum, this work, advanced in a series of essays, linked risk and return, and suggested that the market operated "efficiently", and was therefore hard to beat.

If indexing hasn't changed at least, fundamentally what has? The answer lies in people's perceptions. In the early days, the popular reaction to index-tracking investing was broadly hostile. In the US, index investors were seen as outsiders, with opponents drawing on McCarthyite language by branding them "unAmerican". The idea that any full-blooded American should aspire to the average, to mediocrity, was repellant to the Wall Street establishment. "It is a formula for a solid, consistent, long-term loser," said one contemporary.

But, as William Fouse, the pioneer of the first index fund for pension schemes, and John Bogle, the founder of the first index fond for retail investors, argued from the beginning: over the long term, the fund manager who, year in year out, delivers the average return is a high achiever. Not for nothing do index-tracking specialists hire top flight mathematicians.

Today, it has become clearer that, as Pattie Dunn, chief executive of Barclays Global investors, the world's biggest index-tracking fond manager puts it, index-tracking is "the classic hare and the tortoise business".

Index-tracking firms no longer need to resort to clever rhetoric to make their point: active fund managers, brilliant one year baleful the next, have made the case for them. In the UK, four of the "big five" fund managers tripped up in the late 1990s, and the impact on the index-tracking business has been dramatic. In 1990, 16 per cent of the top pension funds' assets were indexed, according to Greenwich Associates, the US consultancy. By 1999, this had risen to 28 per cent. Of course, there are exceptions. Warren Buffett, the sage of Omaha, is often named as an example of an active manager who consistently outperforms the market. But, as Mr Bogle says: "It's harder to name two." He adds that Mr Buffett "thinks like an index investor: he buys a few large stocks, holds them for a good holding period - forever - and it's worked quite brilliantly".

If consistency is the indextrackers' forte, so too is cost. They are significantly cheaper than their active rivals, charging fractions of 1 per cent for their services.

Index-tracking specialists - so often termed 'passive" managers - reject the criticism that they are cheap because their investment technique amounts to little more than pressing a button on the computer.

As David Rough, director of investment at Legal & General, one of the UK's largest index-tracking fund managers, says: "If you told my colleagues they were passive, they would take it as an insult. To do well, you have to manage actively: you can't just come in for half an hour in the morning and press a button." Yet, they do not undertake the kind of expensive research and trading carried out by the active stock pickers.

The merits of index-tracking - the steady returns, the low costs - have manifested themselves over time, and this, in turn, has prompted investors' advisers pension consultants and stockbrokers - to alter the shape of the typical portfolio of investments.

Today, advisers favour the so-called diversified core-satellite approach: a sophisticated version of the old adage that you shouldn't put all your eggs in one basket. Usually, this means anchoring the core part of the portfolio by using index funds, and allowing an array of orbiting satellite funds that are actively managed to deliver high returns.

If index-tracking specialists have commercially benefited from the mistakes of active managers, they have further benefited from the widespread "restructuring" of pension fund portfolios along the core-satellite model - a strategy promoted as a protection measure for investors unduly reliant on one or two fund managers.

The scale of this restructuring can be gauged by, among other things, observing the rising popularity of specialist, and in particular hedge fund, managers. Last year, for instance, the proportion of large UK pension funds that hired specialist fund managers to run satellite funds rose to 64 per cent - up from 40 per cent two years before, according to Greenwich Associates.

Going forward, the index-tracking industry can expect to get larger, attracting more assets and more fund managers. To date, the industry has been dominated by a handful of large players: BGI, State Street Global Advisors and Vanguard. This is because it has traditionally been a low fee and therefore low margin business that only makes commercial sense on a large scale.

The barrier to entry for the "plain vanilla" product is high, with a clear "first mover" advantage. It is not surprising that BGI (through its acquisition of Wells Fargo's old fund management business) and Vanguard were the pioneers of, respectively, institutional and retail index-tracking investment.

On the other hand, "enhanced" index-tracking, where fund managers try not only to match but also to beat an index by up to 1 per cent, is luring the traditional active managers, who are exploring all ways of wooing back clients - and assets - they have lost over the past five years. Merrill Lynch Investment Managers, which hired Bankers Trust's quantitative team, recently launched a series of enhanced funds. JP Morgan, a large active fund manager, is rated the second largest manager of enhanced index funds, with Dollars 53.3bn, according to Pensions & Investments, the US-based trade journal.

If the prospects are good for the index-tracking industry, there is just one, but significant, uncertainty: the impact of the downturn in the world's stock markets. Ms Dunn, of BGI, insists that index-tracking specialists should fare well. After all, she says, the investment strategy grew up during the dark days of the early 1970s bear market. But the jury must be out, since it wasn't until the long bull market was well under way in the 1980s that indextracking investment started to win first professional and then popular approval.