In the world of indexing, ETFs are the most notable beneficiary
Indexing and the investment instruments based on it are topics of great interest for very good reason. In 2017, Pictet Asset Management issued a much-cited analysis that said index-tracking funds and passive management vehicles already controlled up to 40% of US stocks, and could own the entire US stock market by 2030 at the current growth rate.
However, such over-concentrations have been the heralds of major black swan events in financial markets in the past. And there are also many vociferous critics of the entire subject of passive investment. So it’s time for an objective look at the pros and cons of indexing and index-tracking, and whether it really justifies the outsize position it has assumed in investment and asset management.
Position and methodology
The underlying process of indexing which powers the investment is, in theory, methodical, stringent and very much rules-based. This ought to be a godsend for those who seek clarity and simplicity for their investment decisions. But it does raise the question of how genuine that transparency and simplicity is.
Rob Hughes, head of index and adviser solutions for Nasdaq, extols the work of index providers in allowing asset managers and investors to “set a course based on a rules-based, data-driven strategy at a low cost”. He believes that the index providers have been very effective in delivering on their promise, empowering advisers with market access, lowering costs, and making a gamut of passive investment strategies possible.
Mark Hui, head of global equity beta solutions for Asia ex-Japan at State Street Global Advisors, also points to low cost and transparency of index-based investing. This transparency is part of the changing investment dynamics that have made passive investing relatively more attractive in the first place.
“Increasing market efficiency and faster information flow have made alpha generation harder than [it was] in the old days,” Mr. Hui says. As investors become increasingly sophisticated, they demand deeper insight into investment philosophy and process – which index-based approaches are well positioned to deliver.
Frank Siu, executive director for index solutions at Axioma, sees indexes as serving three major functions: they act as market barometers; they provide benchmarks for specific market segments; and they provide a basis for tradeable products offering a specific type of exposure.
Indexing hence provides the basis for passive index tracking, following benchmarks in a particular market or region, or even sector, and often put together by straightforward market capitalisation-weighted approaches.
Jonathan Howie, head of index strategy Asia Pacific for BlackRock, frames indexing in the whole context of asset management and portfolio allocation strategy. In his view, indexing “represents the most efficient way” for investors to achieve their desired allocation across the gamut of asset classes, including stocks, bonds, real estate and infrastructure.
According to Mr. Hui, indexing makes the methodology of the underlying benchmark and frequency of rebalancing transparent to investors in a rules-based framework that leads to lower management fees and deeper understanding. However, this assumes investors can understand and appreciate the benchmarking methodology, and make informed investment decisions based on it.
Not everybody is as sanguine about indexing. A memorable headline in a Bloomberg column once asked: “Are Index Funds Communist?” It argued that passive index tracking undermined the fundamental purpose of stock markets to allocate capital to good companies and away from bad ones. According to the columnist, active management and active allocation decisions deliver economic and even social goods as well as investment returns.
There can be little argument that the broad spread of index-tracking investment approaches makes markets more correlated, and increases the tendency of investors to move in lockstep.
Another Bloomberg article described passive management as “somewhat tantamount to a nihilistic approach to capital allocation,” because it simply allocates to entities in the market regardless of actual performance or relative quality, purely by virtue of their current presence. That may be an extreme interpretation, but it does make intuitive sense.
Index investments in a portfolio
Indexes deliver investment products that allow access to almost any asset class, factor, region, market segment, or other investment ideas. “The beauty of indexing is that it can fit into almost every investor’s portfolio,” Mr. Hui says.
Mr. Siu invites investors to consider an investment proposal: “Provide me exposure to low-volatility stocks with high dividend yields and strong balance sheets.” He maintains that this kind of portfolio can be delivered to investors by construction of an index, and that such indexes are exactly the cost-effective and transparent mechanisms to implement these strategies.
According to Mr. Hughes, exchange-traded funds (ETFs), exchange-traded products (ETPs), and their sister instruments “are the most well-known products based on indexing.” He views these as now being an essential part of any portfolio. He says investors, especially in the Asia Pacific region, are increasingly embracing ETPs, which have lower costs.
Mr. Howie says strong inflows into index products across the entire asset management industry in the past few decades has driven improved portfolio efficiency and lowered costs, with greater liquidity and transparency. He points out that investors can access indexes through instruments other than ETFs, including mutual funds and separately managed accounts. The exact choice of vehicle depends on investor needs.
Some investors may opt for a mix of all three to meet their goals. Mr. Howie believes ETFs are best for managing liquidity, increasing diversification or making tactical allocation shifts, while mutual funds and separate accounts can cater to bespoke needs, or access through specific platforms.
There is no doubt that ETFs have been the most conspicuous beneficiary and vehicle of the indexing revolution. Their virtues are well known: low cost, transparency, and liquidity, trading like any other instrument on a stock exchange.
While a product like the Tracker Fund of Hong Kong, where the ETF is itself a major constituent of the market it tracks, could raise some interesting questions about this approach, most ETFs are more precisely focused and linked to a more specific index.
Mr. Siu describes ETFs as a “wrapper”, enabling investors to gain exposure to the complex portfolio strategy embodied in an index. The index itself is a means of encapsulating and systematising this strategy into a series of returns, he says. Arguably, this can offer investors more transparency and robustness than in an actively managed fund.
He points out that the indexes underlying ETFs are constructed “according to a set of pre-determined and fully disclosed rules.” With no discretionary element, they are also low-maintenance, except for rebalancing periods, and consequently, low-cost.
Mr. Hughes believes that the exponential growth of ETFs over the past few decades is “proof of their effectiveness”, giving investors large and small exposure to new strategies at low cost and opening access to some of the world’s top companies.
ETFs have certainly proven their point in terms of scale. Brown Brothers Harriman’s 2019 global ETF investor survey pegs global ETF assets under management at US$5.1 trillion at the end of 2018, with the US accounting for over 70% of the market, or nearly $3.6 trillion, and Europe at $793 billion.
The entire industry springs from the development of indexes, although interesting trends also observed in the survey include increasing demand for “actively managed ETFs” which, if not an actual contradiction in terms, raises questions about what investors demanding such products are really looking for.
Some market observers are probably also right to conclude that the surge in ETF demand owed much to shifts in investor sentiment after the global financial crisis. As with many other asset classes, investors lost confidence in active strategies and mutual funds when these weren’t able to protect them against the huge market declines in the wake of the crisis in 2008. The relative attractions of passive versus active management got a considerable boost in that climate.
Moves following the crisis, such as BlackRock’s acquisition of Barclays Global Investors – and its key iShares ETFs unit – helped in that shift. Notably, BlackRock, now the world’s largest asset manager, had almost $6 trillion of assets under management as of 2018, more than the entire global ETF market, while bond management giant Pacific Investment Management Co, or Pimco, has $1.66 trillion of assets.
The separation dilemma
But there is one abiding issue around index-based passive investing that evokes memories of the financial crisis and the conflicts of interest that led credit ratings agencies to assign favourable ratings to financial products underlying the US housing bubble.
The index providers are exactly the entities which are supposed to be providing the neutral, impartial markets that the indexes track. FTSE, S&P Dow Jones, Stoxx/Deutsche Börse, and most of the world’s major exchanges and ratings agencies are there, as are financial information providers like Bloomberg.
Mr. Siu acknowledges that “there is increasing coordination between index providers and investment managers, and this convergence has almost certainly been driven in part by the increased adoption of ‘smart beta’ and enhanced indexing strategies”.
Mr. Hui similarly identifies a “very close” linkage between index providers and funds. In his view, this is more than funds picking the right index provider for their product. “Most index providers will have a fund manager as part of their committee in order to improve the effectiveness of their indices,” he says.
He also points out that index providers sometimes rely on fund managers to help their understanding and reach in “the practical world of investment”. An index must be replicable in order for it to succeed, but the ones who can deliver the best feedback on how well an index succeeded are the fund managers, he says.
Transparency into the methodology underlying an index or benchmark is not going to help much if the index or benchmark has been structured in the first place to serve the needs of a particular investment product. Yet the index providers are paid by the investment managers, and naturally have an incentive to deliver what the client wants.
Mr. Siu notes that even among traditional capitalisation-weighted market benchmarks, industry-wide price pressure and fee compression have pushed index providers into closer collaboration with portfolio managers. This allows them to continually redesign and fine-tune their indexes to reduce trading turnover, ensure liquidity, and achieve easier rebalancing. The cost in independence, however, is obvious.
Others are less concerned about this convergence. Mr. Hughes maintains that there is clear separation between the indexes and the investment products that track them, and that “this distance is one of the benefits of the index business”. In his view, “the two live in separate realms”.
Similarly, Mr. Howie asserts that “third-party index providers are clearly distinct from fund providers”, and that the latter need to keep a relationship with a broad range of index providers in order to address the full range of investor needs and bring the best product to market.
But the proliferation of passive investment strategies and their associated indexes deserves close scrutiny, not least because of the risk of potential conflict of interest among index providers. Financial crisis-style conflicts of interest is not something anyone would wish for in an investment that could be in a position to take over the entire US stock market.