Index Investing

Conventional wisdom says index funds are all the same—passive investment vehicles that track benchmarks, right? Wrong! Index funds have proliferated, and retirement plan advisers must now do more than work through the question of active vs. passive management. To be of utmost value to their clients, advisers must understand fund composition, the benchmarks used, the analysis needed when benchmarks change, the role of target-date funds (TDFs), manager selection and more. On a recent webcast, moderated by PLANADVISER Global Editor-in-Chief Alison Cooke Mintzer, Robert Barnett, sales leader for Wilmington Trust Retirement and Institutional Services Company; Sara Shores, CFA, director and head of U.S. Index Strategy within BlackRock’s Beta Strategy Group; R. Samuel Fraundorf, president of Wilmington Trust Investment Advisers; and Scott Revare, CEO of the Center for Fiduciary Management, explained the nuances of indexing.

PA: What, specifically, should financial advisers know and understand about indexing in today’s defined contribution (DC) plans?

Barnett: We’ve seen a growing popularity in the use of indexing in defined contribution and defined benefit (DB) plans over the last decade. As we’ve seen that growth, we’ve learned the advantages and disadvantages of both active and passive management—and how fund managers should be evaluated and monitored.

Shores: There’s been a dramatic increase in the presence of index funds, both in the defined benefit and the defined contribution market.

A recent McKinsey study estimated that the footprint of index funds in defined contribution portfolios would increase from 9% to 16% by the end of 2010—and to 24% by 2015.

In the aftermath of the credit crisis, the ability of an index fund to track its benchmark is really attractive to a lot of investors, so we expect we will continue to see index funds become an even more significant part of defined contribution portfolios.

If asset allocation is the most important decision to be made, index funds provide the desired exposure in a low-cost, efficient and transparent way. However, it is important to understand that not all index funds are created equal, and there can be a significant difference in the performance among what appear to be essentially identical funds.

Even for an index as straightforward as the S&P 500, there can be marked differences in the realized returns across providers. So, if not all index funds are created equal, how are advisers like you meant to select their next fund?

Performance is absolutely the most important thing to consider, alongside risk management and costs. And while a fund’s expense ratio is important, the difference in performance between one fund and another can be multiple times the difference in expense ratio. So it’s very important to consider the total performance experience of participants, and that includes the expense ratio, the total returns and consistency of those returns.

As an index manager, our job is to seek to deliver benchmark returns, year in and year out. And that is actually a very difficult job. The benchmark assumes that the world is frictionless and that every corporate action and every index change is reflected instantaneously and free of charge. Of course, in the real world, you have to take into account commissions and taxes, market impact liquidity and the fact that not all benchmark assumptions are actually replicable by portfolio managers. To be successful in delivering that benchmark return consistently, we have to carefully understand and weigh all the different sources of risk and cost within an index fund. This framework of looking at performance, risk and cost is also a really useful framework for reviewing index funds and index fund managers.

So, with all of that in mind, how do you go about selecting index funds? Asset allocation and benchmark selection is really the first step in the decisionmaking process. From there, a careful evaluation of the total performance experience delivered by each index provider will help ensure that your clients have the best possible outcome.

PA: What key factors should financial advisers focus on when integrating a passive and active strategy?

Fraundorf: When you consider building an offering that includes active and passive strategies, a wonderful place to start is by thinking about it from the perspective of the investor. Ask yourself, what do they want and expect?

Having some passive investments available in a retirement plan is extremely important. As you lower the overall portfolio volatility, you should increase the probability of participants’ success in the long run. To decide how many active and passive options you might want to have available in your offerings, you need to answer three questions:

One is, “How much tracking error can you or your client endure?”

The second is, “How good are you at choosing active managers?” If this is an area of strength for you, then it is plausible that you may be comfortable with a larger allocation of active solutions in your plan. However, if this is not where your expertise lies, more passive vehicles may need to be considered.

And, finally, “How long is the evaluation period?”

Given a manager’s expected alpha and tracking error, we can estimate the probability of underperforming a target benchmark over different horizons. The ratio of alpha to tracking error is a manager’s information ratio. The higher the information ratio—and the portfolio constructor’s ability to identify and source the manager—the more likely the portfolio will benefit from active management.

Besides managing tracking error, the addition of passive management to a portfolio can lower your average investment management fees, lower the cost of overlays for portfolio insurance and allow for efficient equitization of cash. Having a low-cost solution in a plan increases the client’s opportunity for success over the long term.

Large-cap managers in the U.S. have slightly lower tracking errors than small-cap managers (see Figures 1 and 2). So, what would be beneficial for someone thinking about building portfolios is having passive anchors, which allow for actively managed satellite assets with higher tracking errors.

PA: Practice efficiency and adding value to plan sponsors is paramount, how can tool providers help financial advisers?

Revare: The primary objective as a tools provider is to make sound evaluation criteria and current data available to our customers. When we look specifically at fund evaluation in today’s index space, there are several things to consider.

There is typically not much differentiated analysis within a plan. One evaluation model we use in our system, FiRM, focuses on an index-based fund in a side-by-side comparison with mutual funds, being certain to use the same evaluation criteria. We direct our advisers to choose the criteria on which they want to perform the evaluation: the fund manager attributes, how long the manager has been there, how long the firm been there—and how big the fund is across different time frames, modern portfolio theory and risk/return criteria. These make for readily available comparisons against peer groups meeting the benchmarks.

With the drawbacks of the one-size-fits-all approach on criteria, there is a pretty strong case for putting unique criteria for index-based funds within these tool sets; and we do so with FiRM. Looking forward, our direction is to choose separate monitoring criteria for index-based funds while allowing the adviser, in conjunction with the plan sponsor, to select and weigh criteria based on each plan sponsor’s unique needs.

To understand monitoring index funds on an ongoing basis, let’s look at the evaluation criteria. Typically, there are two setups. One is to take the measurement criteria and compare the criteria to one of three types of parameters: a benchmark, a peer average or a type of a threshold—such as a fixed number.

It is key to focus on how closely the fund adheres to its target index with regard to tracking error and tracking difference and thresholds versus peer quartiles and averages. Other important questions to consider: Is the index the best choice to use? How well does the underlying index represent an asset category? What are the liquidity and diversification implications?

Typically, advisers use adherence to the benchmark and peer rankings. That’s why we emphasize studying these and factoring in their relevancy. Performance, of course, is always relevant. Expenses have to be relevant, as well. It’s vital to look at the expense ratio of the fund. The track record of the fund and manager is also very important as we look at savings, trading costs and performance contributions.

We can’t close without bringing up the matter of liquidity. Clearly, liquidity is going to be more and more important as index fund use expands into new market segments.

In addition to the ancillary factors described, each analysis must begin with something fundamental—the requisite data. The challenge of making these index fund analyses work is to provide the essential data for each analysis. It has become inherent in this space for tool vendors to supplement data from vendors with data directly received from fund companies. Only with the correct and complete data—and the options described above—can an adviser make a sound decision regarding the analysis of a plan’s potential new fund.

Investments are not FDIC insured – No bank guarantee – May lose value

Wilmington Trust is a premier provider of wealth and investment management, including retirement plan administration and manager selection, as well as trust and custody services. As a strategic and tactical asset allocator for high-net-worth, retail and institutional investors, the firm managed $77.7 billion as of June 30 and held about $4 billion in exchange-traded funds (ETFs) and index mutual funds.

Contact Rob Barnett at rbarnett@wilmingtontrust.com for more information.