The other side of tracking

Passive management is growing in popularity, yet the risk profile of trackers can vary enormously. Paul Farrow investigates

The benefits of active management often get lauded as the panacea of investing but index funds are proving more popular than ever when it comes to where pension funds want to put their money.

A recent survey from Hymans Robertson showed that major active managers lost business while the big index players continued to thrive – and made up the top three managers with pension assets under management. The survey highlighted that UBS Global Asset Management, Capital International and Fidelity International all saw their assets fall by a fifth during 2007 as poor investment performance led pension funds to take their assets elsewhere.

Their passive counterparts had a bumper year. Legal & General (£212bn) and Barclays Global Investors (£101bn) lead the way. “Last year was pretty bad for active managers so trustees are rethinking the benefits of passive investment,” says John Hastings, partner in the investment practice at the consultancy Hymans Robertson.

Yet while passive investing continues to thrive there are concerns that in the DC and GPP market many employers and employees are unaware that performance can vary greatly and that many index funds are not the low risk vehicles they are perceived to be. The concern is compounded because many are default funds – and it is well-known the majority of employees just tick the default box when it comes to their workplace pension.

According to the 2008 PensionDCisions Default Investment Strategy Survey, 25 schemes (out of a total of 43 surveyed) use a “global equity tracker” as default fund. The highest UK allocation within this sample of global equity tracker funds was 70 per cent and the lowest UK allocation was 30 per cent, with a median of 50 per cent. Allocations to other regions (particularly the US) differed too.

The diversity in asset allocation has resulted in a disparity in performance. According to the survey the worst performing global equity tracker (over three years) had an annualised performance of 12.9 per cent, while the best performer returned 15.6 per cent for the 3 years to December 2007, a differential of 2.7 percentage-points annualised. In other words: £1,000 invested three years ago in fund A would have yielded more than £100 more than £1,000 invested in fund B.

“The fact sheet for the worst performing fund shows that it has actually outperformed its benchmark by 0.1 percentage point, while the fact sheet for the best performing fund shows that it has underperformed its benchmark by 0.2 percentage points: because the benchmarks of the funds reflect the underlying geographical allocations, the significant performance difference is not captured by a comparison with benchmarks,” says Dietrich Hauptmeier, finance director at PensionDCisions.

Experts agree that there is a significant difference between index funds offered – and the disparity is even greater when comparing trustee run schemes and contract-based GPP schemes. They say that trustees are becoming switched on and are willing to embrace the new world of passive investing. Yet in the contract-based GPP market the employer does not take much of an interest which is why many tracker funds on offer may simply be a UK equity fund that it has offered for years.

“GPP schemes are in a time warp,” says Ian Richards, head of DC strategy and governance at Legal & General Investment Management. “Many trust-based DC schemes are adapting and evolving but contract-based schemes effectively put the individual into the position of trustee – and they don’t do a thing.”

Richards has little doubt that many GPP schemes continue to have UK equity trackers as defaults, which is putting undue risk on employees pension pots. Being exposed to just the UK is a risky strategy and blows out the water any notion that tracker funds are low risk. A handful of stocks make a large chunk of the FTSE100 index. BP, for instance makes up 8 per cent of the index and HSBC 7.2 per cent. It means the oil and gas sector makes up one fifth of the index while banks around 15 per cent. A knock in confidence for the oil stocks will have a heavy influence on the performance of the footsie.

Patrick Race, principal at Mercers, says the concentration of stocks that make up the FTSE is seeing some pension funds managed by trustees reduce their exposure even further. “A lot of schemes are now reducing their UK content to 50:50. The UK market is heavily reliant on a small number of companies and sectors such as oil and financials – so it seems to make more sense to add overseas exposure.”

Richards says that he has even seen schemes with 80 per cent exposure to global indices and just 20 per cent to the UK. “Once we go below 50 per cent weighting in the UK we put in a currency hedge to reduce the currency risk.”

It is not just the make up of asset allocation that differs with index fundsthe index players use different strategies to track different indices. Lee Smythe at Killik argues that very few accurately track their chosen index and should by nature under perform the index slightly due to the charges. “However, as most trackers are not managed by “full replication” of the index, we do see some trackers greatly underperform. Trackers therefore tend to provide more or less average performance in a sector whereas actively managed funds are more likely to provide top (or bottom) quartile returns.”

There are three key strategies – replication, sampling and optimisation. Trackers that fully replicate the index buy and sell when stocks enter and leave indices. A tracker that samples, on the other hand, will only exactly replicate the big stocks in each sector, be it banking, pharmaceuticals or telecoms. It will then take a sample of the remaining stocks in each sector, holding a little bit more of one and less of another. However, the actual weighting of each sector in the tracker fund will be the same as its weighting in the index it is following.

Colin Tipping, client director at BGI, argues that full replication is the most efficient in terms of costs and returns for the big indices such as the FTSE All-Share or S&P500, whereby sampling or optimisation is better for the less efficient markets such as Japan or emerging markets.

“It makes sense to adopt a passive approach for the US – a market which many active managers find difficult to outperform – opportunities to add value are scarce. With optimisation you may pick certain characteristics in the index sub sectors and pick just three of the five stocks available,” he says. “Tracking error is what is vital. BGI aims for a tracking error below 0.2 per cent on the major indices and under 1 per cent on the more esoteric indices.”

One of the drivers of index popularity amongst schemes is, of course, cost. Index funds have long been famed for their lower feesactive fees which are higher can be a drag on performance, but, even for passive funds, fees can vary significantly. Obvious cost drivers such as plan size and contribution rates go some way to explaining variations in fees, but much is left unexplained. “Some trustees and plan sponsors reading this report may wish to think hard about whether their members are getting a good enough deal on fees”, warns Alistair Byrne, senior lecturer in finance, University of Edinburgh Fellow of the Pensions Institute.

Byrne says that trustees and sponsors may wish to consider whether the almost complete reliance on equities is appropriate. “As defined benefit plans consider liability driven investing, many are migrating the ‘growth’ component of their assets to a diversified approach, encompassing a range of traditional and alternative asset classes,” he says. “This diversified growth approach would seem sensible for DC plans too.”

There is little doubt that diversification is the current buzzword in investment circles but you do not need to be in an actively managed fund to get a piece of the action. LGIM, has launched three index-tracking funds that enable DC schemes to gain additional exposure to specific sectors of the market – infrastructure, private equity and real estate investment trusts.

Richards says: “There are many global listed securities that do not fall within the main geographic regions tracked by the FTSE World series of indices. By adding specialist funds of this nature, trustees can tailor their portfolio to get the degree of exposure required.”

He adds that active management can also be built into a passive asset allocation strategy. “An index buffer zone can be added to the sector to be managed actively, to absorb the market fluctuations.”

BGI, also offers indexed funds including commodity, private equity and infrastructure – and is seeing an increase in demand not only from trustees, but from Sipp investors too. Tipping adds: “Traditionally there had been a focus on UK equity and UK fixed income but diversification led trustees to put building blocks in place for global diversified portfolios. It has now gone further, to so-called multi asset. Commodities, private equity and infrastructure are generating interest from trustees.”

But despite the likes of BGI and L&G offering passive alternatives, not everyone agrees that index funds and alternative assets mix. “When it comes to alternative assets I’m not sure they should be trackers – the best advice is to go active,” says Race. “I am also not sure a blend of passive and active works either. I think we could be going full circle back to multi asset funds that smooth returns in the way with-profits promised to do.”

Julian Webb, head of DC at Fidelity, argues that trackers are not necessarily the right solution because they are not the low risk they are often perceived to be – as they are often 100 per cent equity focused. It is why Fidelity – along with others such as Schroders, JPM and M&G have launched UCITs III friendly multi-asset funds – cautious managed funds that invest in property, hedge funds and private equity – as well as bonds and equities.

“Because of this risk-return profile we are already seeing DC schemes considering the fund as a default option for members,” says Webb. “We know that most default strategies are typically index-tracking funds, but our research threw up an interesting anomaly: schemes like the passive option because of low fees and perceived low risk but many also select them for their potential to out-perform. The new funds can tick all of these boxes, thereby helping scheme members to build their pension pot effectively and get ready for retirement.”

Passive funds in the DC and GPP marketplace certainly face stiff competition from the new breed of multi-asset funds. But the likes of BGI and L&G will not be quaking in their boots. There has been no conclusive argument against passive funds in favour of active strategies, yet they remain simple to understand and they are cost effective.

The big two will continue to dominate. Just do not suggest to a passive fund manager that they turn up at 7am, turn the computer on, put their feet up and switch it off at the end of the day when the market closes. It gets their backs up. “We are more active than active managers,” says Tipping. “It takes skill and a great deal of analysis to track an index closely.”