So institutional assets in index funds alone in the US were $1.6 trillion at year end 1998, after more than doubling from 1995 to 1998. Of the nearly 1500 institutional funds followed by Greenwich Associates, 24.4% of their total assets are invested in passive management strategies. Since the bulk are probably indexed to the Standard & Poor's 500, that's similar to a fifth or a quarter of the industry investing with the same money manager. How likely is it that you would ever get that much agreement in this industry?
The list of heavy indexers is impressive. California Public Employees' Retirement System is the largest pension fund in the US with over $130 billion. About 80% of its funds invested in domestic equities are indexed, and about 85% of its assets invested in international equities are indexed.
"We've always been heavily indexed," said Brad Pacheco, spokesperson for CalPERS. "We're a long-term holder, and that primarily is what passive investment is." The New York State Common Retirement Fund, the second-largest pension fund in the country, is about 40% indexed; the California State Teachers'Retirement System, the fourth largest pension fund, about 50%.
So where does the investment industry go from here on indexed funds? We decided to sample in depth the views of a few of the most strategically placed investment minds in the industry, so you can consider what they have to say, and see where you stand in comparison.
"If you get some plan like the GEs or the General Motors of the world, and they have $13 billion that they need to invest, almost by mandate they have to have some indexing," said Andy Bednarz, Manager of Benefit Plan Investments for Occidental Petroleum. "They can't buy enough of 14 companies to make a difference in their portfolios, so they have to have some sort of a core portfolio." He thinks it's reasonable for a plan holding $6 billion in assets to index $4.5 billion and divide the rest among a few active managers. Yet Bednarz himself is not investing Occidental's money that way; he's going entirely active.
Larry Tint is Vice Chairman of Barclays Global. At the top of perhaps the biggest index investor on the planet (over $600 billion under management), he is an indexer's indexer, and naturally he largely agrees with Bednarz's assessment.
"On one hand the large funds are sort of more capable of doing the research necessary to find the asset managers who they expect to win the game. But the law of large numbers also starts working to some extent to their disadvantage," he argues. "If you're running a $50-100 billion portfolio, the odds that you can find enough managers who can take the size asset that you have without completely overwhelming their investment selection process is zero." [For a taste of how complexity of management can expand as the number of managers expands, see Alldredge's article, p. 34 - Ed.]
Tint said most of the very large funds in the US have structured their portfolio around an indexed core and use active managers as peripheral investment strategies.
"They understand that they might be able to find six, eight, or ten managers who are going to outperform in certain niches. They can create the overall structure they want using index funds and let these managers have chunks of their assets large enough to be significant but small enough to not overwhelm the management process," he said. So even the indexer's indexer is not entirely opposed to active management.
Greenwich Advisers found that indexed 24.4% is an average of a pretty wide spread: Just 15.4% of the combined total assets of the 877 corporate pension funds surveyed by Greenwhich were indexed. The 342 public pension funds, however, had invested 34% of their combined assets in index funds. Endowments, interestingly, had the least amount invested in index funds, at 12.7%.
"Public funds generally seem to have more indexed assets (than corporate funds) largely because of the low costs," explained William Madden, a principal with Ennis Knupp & Associates, an investment consulting firm that has developed a national reputation, gets no revenue from money managers or commissions, and advises every important type of investment fund. He might have added that indexes give government investment decisions valuable political cover: They are, or can seem, politically neutral.
Obviously, there is a question of whether or not indexing is right for every institutional fund and for all types of assets. Tint again, who obviously believes it is the most logical course for any investor and any asset:
"When the index fund buys, it buys a little bit of every stock exactly in proportion, so the active managers as a group don't gain or lose by selling to the index fund. When they trade with one another, they also aren't gaining or losing as a group except the brokerage community is siphoning some of the money off. In other words, if you have a really, really smart active manager and he buys all the right stocks, who is he buying them from? He's buying from all the active managers who are really stupid and selling him all the stocks. The fact is that as a group, they have the same portfolio as they did before, except that they've spent money with the brokerage community. So the group as a whole can never beat the index," he said.
But remember, Tint isn't completely against active management. "If you're small enough and you have a good enough manager selection methodology that you can be the one that finds the winners, that's terrific. It's just that it's a very, very hard game, because the people who appear to be winners are competing with one another in a negative sum game. The net effect of that is that most of them will lose, in spite of the fact that the people who hired them thought they were all going to win."
Tint dismissed the concept that indexing only works in efficient markets. BGI has over 300 index funds covering markets throughout the world and a wide variety of asset classes, he noted.
"There's no reason that the concept of indexing does not apply to any of those sectors of the market nor is there any reason to think it's not as valid," he said. Tint cited the emerging market of Zimbabwe, on which BGI bases an index fund, and noted that it was a highly inefficient market with high costs, a limited number of securities, and not as much regulation as the US market. However, Tint said, the same rules apply as in the US. The active managers struggle with each other, and not all of them can win.
|SEC FILINGS FOR NEW INDEX FUNDS|
|American Express Financial Corp.||AXP Market Index Fund||S&P 500 Index||August|
|AXP Mid-Cap Index Fund||S&P Mid-Cap 400 Index|
|AXP Broad Market Index Fund||Wilshire 5000 Equity Index|
|AXP International Index Fund||MSCI EAFE|
|AXP Aggressive Index Fund||Nasdaq 100 Index|
|AXP US Bond Index Fund||Lehman Brothers Aggregate Bond index|
|TD Investment Management Inc.||TD Waterhouse Bond Index Fund||Lehman Brothers Aggregate Bond index||August|
|TD Waterhouse 500 Index Fund||S&P 500 Index|
|TD Waterhouse Extended Market Index Fund||Wilshire 4500 Equity Index|
|TD Waterhouse Asian Index Fund||MSCI Pacific Free Index|
|TD Waterhouse European Index Fund||MSCI Europe Index|
|TD Waterhouse Systematic Technology Fund||Goldman Sachs Technology Index|
|Sentinel Funds||Sentinel Growth Index Fund||S&P/Barra Growth Index||August|
|Ranson & Associates||Unnamed; Eagle Fund family||Nasdaq 100 Index||October|
|Mercury Asset Management||Index Master Series Trust with four feeder funds||October|
|Mercury S&P 500 Index Fund||S&P 500 Index|
|Mercury Small Cap Index Fund||Russell 2000 Index|
|Mercury Aggregate Bond Index Fund||Lehman Brothers Aggregate Bond index|
|Mercury International Index Fund||MSCI EAFE|
|Carillon Advisers Inc.||S&P 500 Index Fund||S&P 500 Index||October|
|S&P Mid-Cap 400 Index Fund||S&P Mid-Cap 400 Index|
|Russell 2000 Small-Cap Index Fund||Russell 2000 Index|
|Nasdaq 100 Index Fund||Nasdaq 100 Index|
|Balanced Index Fund||S&P 500 Index and Lehman Brothers Aggregate Bond Index|
|Lehman Aggregate Bond Index Fund||Lehman Brothers Aggregate Bond index|
|AAL Capital Management Corp.||AAL Large Company Index Fund||S&P 500 Index||November|
|AAL Mid-Cap Index Fund||S&P Mid-Cap 400 Index|
|AAL Bond Index Fund||Lehman Brothers Aggregate Bond index|
|McMorgan & Co.||McM S&P 500 Index Fund||S&P 500|
|Barclays Global Investors||US 5000 Index Fund (feeder)||Wilshire 5000 Equity Index||August|
|EAFE Index Fund (feeder)||MSCI EAFE|
|ProFund Advisors LLC||Small Cap ProFund VP Fund||Russell 2000 Index||August|
|TD Waterhouse Asset Management||TD Waterhouse Dow 30 Fund||Dow Jones Industrial Average||August|
On the other hand, Tint added, "That doesn't mean that you can't find opportunity." BGI has an enhanced index fund that mostly mirrors the S&P 500 but is invested more heavily in high-yield stocks on the basis that they are out of favor. That fund, started 20 years ago, has outperformed the S&P 500 by an average of about 40 basis points a year, he said. But he cautioned that the good returns could come to an end at any time if others saw the benefits and high yield stocks suddenly became widely popular.
Madden, the consultant, thinks indexing is a good idea for most institutional funds, but only for some asset classes.
"I think [indexing] is a very good thing, particularly in large-cap stocks where you find there's a tremendous amount of correlation from one manager to another and with the market," he said.
"Sometimes the bottom line is closet indexing," Madden continued. "What we try to do is take apart a person's portfolio and look at the level of risk they're taking right now relative to the benchmark and say 'Is there a cheaper way to deliver the same amount of return expectations?' And often in some of the analyses I've done, we've said we could put fifty percent of this in an index fund and still hire some really good managers who may underperform from time to time but maybe over the long term will add some value," Madden said.
Madden certainly does not find active management impractical; but he thinks indexing is most practical for large-cap US stocks. "I do believe in active management," he said firmly.
"We think in the small-cap market there's certainly a lot of indexes around, but there's so many stocks and so much ability to add value that active management is the way to go," Madden said. He says his firm generally has been recommending that clients index roughly half of their investments in non-US developed countries but to use only active management for bonds.
"If you can add 150 basis points, that's a big deal. And by participating in things like high yields or nondollar bonds opportunistically, there's a lot of value to be added by being active."
WHY NOT INDEXING?
Since Bednarz doesn't reject indexing, he discussed why Occidental's pension fund assets were moved out of index funds over a year ago.
"The biggest reason we made that move back then is that the index we were using, the S&P 500, has a lot of growth factors to it. It's a growth-biased index, and it's a large-cap-biased index," he said. "We tend to be a value shop, so we wanted something more of a value manager. We thought we could do that with active management."
"Our philosophy on active management is that our managers have a benchmark that they are supposed to beat, but that's over a full market cycle. We don't hold their feet to the fire." Bednarz typically shoots three to five hundred basis points on average. Enhanced index funds that only outperform the benchmark by 20 basis points or so often have most of their added returns eaten away by fees, he said.
"If I was going to index, the S&P 500 would be the only one I would index to," Bednarz said. He believes active managers are necessary for international and small-cap stocks.
"On bonds, I guess you could make an argument that if you wanted a nice conservative bond manager, you could buy the index and get that a little less expensively by not paying as much in fees. But most aggressive managers can beat the Lehman Brothers Intermediate or Aggregate," he said.
Bill Dougherty, president of Kanon, Bloch, Carre a widely followed consulting company that focuses on (401)k plans, says that upon being named the manager of a hospital's retirement plan, he announced that he wanted to put 30% of the assets in an index fund.
"I was trying to have the core of the portfolio keep pace, and I also was trying to reduce costs. What happened was I got increased returns AND lower costs because the index did well," he said.
While he thinks index funds should represent the core of any portfolio, he too is against a totally indexed portfolio.
ONCE INDEXES LAGGED
"What if we go back to the period like we had in the late 80s and early 90s when sixty to seventy percent of active managers outstripped the market? And that can happen again. So you don't index the whole thing. You stay with a foot in the active manager market."
Dougherty agrees most active managers can't outperform the market but doesn't believe that's an excuse to avoid the active management industry.
"Just because a lot don't outperform, doesn't meant that you can't pick some that do…It's hard, but…the pension funds should be able to identify who the good guys and who the bad guys are," he said.
Tint argues it is possible to construct an institutional portfolio out of index funds. "I think that with the availability of today's multitude of index funds, you can create any kind of portfolio you want out of index funds. You can have a conservative one or an aggressive one; you can have a high cap, low cap, value, or growth portfolio," he stated.
"The only thing you give up is the opportunity to take a bet, which on average is a losing bet."
Madden believes indexing the entire portion of the domestic large-cap segment of a portfolio is not a bad idea but isn't thrilled by the idea of a totally indexed portfolio. "I think you would give up some opportunities across all asset classes," he said.
But what is the future of institutional index investment when the bull market grinds to its eventual halt? T. Rowe Price vice chairman James Riepe recently warned institutional investment professionals about the increasing risk in the S&P 500 at T. Rowe Price's annual symposium, The Baltimore Sun reported. The index's gains, he said, are being driven by fewer and fewer stocks.
With S&P500 index funds holding about 74% of the entire amount of institutional assets in index funds, the future direction of indexing as it relates to institutional assets seems to rest largely with this one index.
"I think (the popularity of indexing) varies with the wind," Madden said. "The last three years, we've seen such strong performance from the S&P500, and everybody's really interested in it. But there's another school of thought that says indexes are overvalued and they're led by a few stocks. And when the air gets let out of those tires, if you index, you'll be in trouble."
Ennis, Knupp surveyed 113 corporate plan sponsors with assets over $500 million, Madden said. When asked if they would increase their exposure to pure index funds, the replies were split pretty evenly between yes and no. But when asked if they would be increasing their exposure to enhanced index funds, the answer was overwhelmingly yes, Madden said.
"I think we're always going to see indexing, and I think its popularity is going to depend on people's outlook on the market."
"I think people might get a little disenchanted if we ever have a severe market correction," Bednarz said. Value managers, he said, might come more to the fore in the event of a significant market correction, especially since the growth-biased S&P500 might correct a little more than a value manager.
Bednarz believes there will be more institutional index products based on a wider variety of indexes and geared to the individual investor participating in a 401K or defined contribution plan.
Tint has no doubts about the direction of indexing in institutional assets.
"I think that indexing as a component of the overall portfolios will continue to grow in the foreseeable future. People every year tell me that it's peaking and it's not going to grow any more. There's no reason to believe that. Indexing would have to get up to a much higher percentage of total assets for an opportunity to be created that would cause people to want to significantly deviate from the trends that they've been establishing for the last few years," he said.
LOVE THOSE CORRECTIONS
As for market corrections, Tint said the severe market correction in the third quarter of 1998 did nothing to reverse the influx of institutional assets to index funds. In fact, he said, it accelerated the trend since the average institutional manager did less well during the correction than S&P 500 index funds.
"Also, I think institutions have become more savvy and don't, in fact, have a disproportionate amount of their money in the S&P 500 any more. Many of them have indexed international assets; they have indexed small-cap assets. They see the S&P as representative of a sector of the market that is normally their biggest sector, but that's because it's the biggest sector of the world market. They've moved to a much more diversified portfolio of opportunities," Tint concluded.