Rapid evolution

14 July 2014   Category: News, Asia   By Tim Edwards*

Investors globally are in the midst of a cost-driven revolution. Consultant PricewaterhouseCoopers is predicting that index-linked investing will double its proportion of global AUM by 2020; the gargantuan Government Pension Investment Fund of Japan (GPIF) has announced it is moving half of its active portfolio to indexed strategies; class action suits have been launched against so-called “Closet Indexers” (active funds that charge high fees to hug their benchmarks); and those looking for a symbolic representation of investor trends need look no further than the fact that hedge funds – the priestly caste of active managers – are likely to lose out to ETFs in the race for global assets for the first time in 2014.

The concept of a revolution is perhaps apt: a recent special report published by The Economist concluded, “Investors of the world, unite! You have nothing to lose but your fund managers’ fees”. The debate for and against indices has never been more lively, or well reported. Yet, even if such predictions are correct, the lion’s share of global assets will remain actively managed (Table 1).

As far as Asia is concerned, on the surface passive investing looks even less popular. The various index-linked products (including ETFs) available have attracted only a fraction of their equivalents elsewhere. Anecdotally, one hears regularly that Asian markets are different: the opportunities for active management greater and the case for indexed strategies accordingly weaker. On the other hand, a new breed of indices offering active-like returns in a passive formats have been gaining traction; the lines between active and passive investments are blurring. What is really going on?

Trend one: active vs. passive

The global growth in passive investing has been historically due to a single, logical observation. If you add up the profit and loss of every participant in the market, you get the capitalisation-weighted average performance (the market portfolio). For some investors to outperform, others must underperform, and to precisely the same extent before costs. From a practical standpoint – a copy of the market portfolio is relatively inexpensive to maintain (rebalancing needs are minimal) and it is unconstrained by capacity; it should achieve returns that are better than the average investor because of those low costs. Multiple studies have shown that on average, active funds underperform in more or less every geography and category. To pick a representative example – in the ten years ending in 2012 – one study showed that over 80% of active mutual funds providing exposure to greater China equities underperformed their benchmark.1

Why, then, are passive investments not more universal in Asia? The challenge to investors – and to the guardians of their wealth – is both practical and structural. Analytical systems and investment processes built to find better-than-average managers are, structurally speaking, designed to reward skill, however the first concerns of passive investing are costs and ability to track the index; forecasting ability is largely redundant. New processes are needed. In the retail market, a distribution system based on free advice and expensive products is naturally biased against cheap products (and undervalues the advice). If the regulatory winds from Europe and the US prevail this may change; it is unlikely to change overnight though.

The practical challenge to passive investing looks at first like an opportunity. It is an investment truism that around 80% of the returns for any given portfolio are determined by the asset allocation. It is also a tenet of modern finance that diversification is the only “free lunch” available to investors. Diversifying risk across assets therefore sounds like a good way to maximise your free calories. But the question naturally becomes one of asset allocation: what is the right mix of bonds versus equities, property versus cash or local versus international? By empowering investors with simple access to entire markets, index trackers have made asset allocation easier. However, with such power inevitably comes an increased responsibility: if your asset allocation resulted in net selling of Indian equities this year, you missed out on ripping performance since Narendra Modi’s emergence as their likely shepherd. With a passive approach to the details, there is no one else to blame for the hits and misses, nowhere “the buck stops”. The change from manager selection to asset allocation requires greater forgiveness of poorly performing investment choices made with good intentions.

Trend two: blurred lines

The first generation of indices were representations of whole markets, albeit typically segmented by sector or geography. They allowed investors to see the highs and lows less as direct evidence of manager skill, but instead as the impact of a broad market “beta”. Accordingly, the first phase of growth in passive investing was driven by low-cost vehicles accessing broad markets; the ability to access hard-to-reach emerging and frontier markets also played a significant role.

Nuanced and more controversial dynamics have driven the second phase of growth in passive investing. The arguments justifying market-cap investing remain inescapable, yet real-world results suggested that additional returns could have been reliably generated from certain well-defined biases: for example avoiding the most volatile stocks, or value investing, or focussing on smaller companies, etc. While the academic community continues to argue whether “factors” like momentum are positive (and, if so, why?), the investment landscape quickly adapted to offer products capturing these factors systematically for clients keen to exploit their perceived value. As the first wave of such products gained prominence, further innovation rapidly brought a veritable cornucopia of alternative, indexed investment styles to the market (Table 2).

Twenty years ago, if you wished to invest only in Japanese value stocks with a positive momentum, you did so directly or via a manager. And if you wanted to evaluate the “alpha” generated by that manager, you did so via comparison to a market index. Nowadays, both investment and comparison can be made with reference to an index that captures both those styles – precisely – and in the relevant market segment. The distinction between “active” and “passive” strategies has become blurred, and the discipline of indexation – together with the lack of style drift that an index methodology ensures – has driven demand for lower-cost versions of increasingly sophisticated strategies.

These two trends combine as a movement from a bar belled system with classical index trackers at one end and active management at the other, towards a blend of each. Such dynamics are writ large and explicitly in the recent move by Japan’s public pension fund mentioned earlier. GPIF’s 129 trillion yen (US$1.27 trillion) of assets make it the world’s biggest public-sector investor; in April this year it announced a restructuring of its equity investments. First, a core passive position tracking traditional Japanese equities is being partly replaced with passive replication of indices that also take factors such as return on equity, value or volatility into account. Second, around half of the actively managed portion will be benchmarked by more specific indices; including for example the S&P GIVI Japan index, which combines both low-volatility and value investment styles. As such large institutions lead, many will follow; it is not unreasonable to expect a significant change in the target allocations and outlook from other Japanese pension funds at the very least as a consequence.

Trend three: Asia ETFs

Even the recent lagging growth of index-linked products in Asia has been deeply understated; the Asian market has suffered from comparisons to its Western equivalents. Much as the youngest child remains smaller and less capable than her brothers or sisters in childhood, direct AUM comparisons are misleading. From the end of 2006 to the end of 2013, exchange-traded products in the US grew at a compounded annual growth rate of 15%; those listed in Asia grew by 15%. The compound annual growth rate of global ETFs over the period was 19% (Europe grew slightly faster). And these figures do not account for the fact that many Asian investors are already using US listed ETFs in their portfolios, adoption is probably wider than a naïve interpretation suggests. It all adds up to a picture of benchmarks and investments evolving rapidly and with indices in remarkably robust health.

* Tim Edwards is director, index investment strategy at S&P Dow Jones Indices


1 https://www.vanguard.sg/documents/case-for-indexing-asia.pdf