August 2008


Nick Fitzpatrick looks at the growth in alternative indices and finds how innovation will help asset managers compete against investment banks to provide structured products ... No sooner than a new investment strategy has been created or a new market identified, then someone has created an index around it. For example, the MSCI Agriculture & Food Chain Indices launched last month come on the back of a string of fund launches this year by asset managers investing in the equities and derivatives of farming companies, food makers and commodities.

There is now an index for virtually every asset class, strategy and geography in existence, and still more are being developed. Such is their proliferation – hundreds of thousands globally – they can go unnoticed.

“We came across the S&P Diversified Trends Indicator (S&P DTI) in Autumn 2005. We couldn’t believe nobody was using it yet. We thought it was a great product and we became the first to link products to it,” said Ingo Heinen, London-based director in the equity and fund  derivatives business at Nomura International, a Japanese bank.

The DTI index sits within a range of ‘alternative’ indices offered by S&P. The desire for alternative investment strategies, such as the commodity and currency futures strategy that underpins the S&P DTI, is a key driver of index innovation. Index providers say they can offer investors cheaper, transparent and risk-controlled access to sometimes hard-to-get-at areas. And thanks to regulatory developments such as Ucits III that allow investment managers to use a larger array of instruments, these strategies are not just for sophisticated institutions anymore. For example, FTSE Hedge Funds Index series is the only Ucits-approved hedge fund index, meaning asset managers can provide hedge fund exposure for retail investors. FTSE says it has several managers using the product and is close to announcing others.

For Nomura, by using the S&P DTI, the bank has been able to bring commodities and currency futures – invested long and short – to a wider range of individuals and institutions by linking the index to an Irish-domiciled Ucits III fund.

“Some clients see the index as a ‘commodity trading adviser’ strategy. Others compare it with a commodity index or use it as a diversifier, as it is slightly negatively correlated to traditional asset classes,” says Heinen.

It was the advent of hedge fund and commodity investing in the pensions market that helped bring alternative indices into sharp focus. Hedge fund indices were seen as a way of avoiding steep fees charged by hedge funds, while more recently new markets are offering opportunities to investors that are searching for assets less correlated to major indices like the S&P 500.

The new, new alternatives
Nomura is putting an interesting twist on alternatives by creating a strategy that relies on mainstream indices.

“Pension funds aren’t just interested in pass-through investments in mainstream indices,”  says Niels Verbeek, vice president of Nomura’s equity derivatives division. “So we’ve come up with research-driven and quant-driven strategies to make mainstream indices, such as those in the US and Japan, deliver uncorrelated returns.”

Verbeek explains that his department is working with quant researchers elsewhere in Nomura bank to provide historical and statistical analysis of when major stock indicators, such as P/E ratios or dividends, are more effective than others at indicating market movements. The top three and bottom three indicators are identified and long or short positions are taken accordingly on the stocks they turn up.

A drawback with index investing is, arguably, that by their very nature indices can only return beta – the general market return that the majority of investors receive. But others will argue that a manager can display skill in choosing the right index at the right time to get risk-adjusted outperformance, or alpha. But for some, particularly pension funds, alpha speaks more about uncorrelated returns, which is what Nomura’s new product line is designed to deliver.

“’Alternative’ in the sense of what we are developing with the S&P 500 index means non-correlation to traditional asset classes. Using traditional indices as a universe for these strategies also means we can build a lot of alternative products that pension funds are familiar with,” says Verbeek.

In recent years it is commodity indices that have seen the largest growth within S&P’s alternatives range. Steven Goldin, Europe and Middle East head of strategy & custom indices for S&P, says “significant billions” are invested in the S&P GSCI, S&P’s flagship commodity index. There has also been high demand for equity-linked commodity exposure through the S&P Global Natural Resources Index and S&P Commodity & Resources Index. Futures-based commodity investors who use these types of indicies are primarily institutional investors, while retail and private clients are a secondary but important category, Goldin says.

Index growth

S&P also has indices based on property and on preferred shares. Goldin says demand has been low this year for property with the exception of the S&P Asia Property 40, launched in June, with about ten Asian-based investment banks and a few asset managers expressing interest in launching products related to it.

As for preferred shares, interest has been driven mainly from the US into exchange-traded funds linked to US and Canadian preferred stock indices. The bulk of preferred issuance has been in North America.

The primary client for new market and new strategy indices in general, says Goldin, has been retail investors and private banks. Institutional investors have been secondary.

“Pension funds tend to have a longer decision making process so they are not early adopters of new strategies including the strategy indices and newer market indices,” he says.

But when it comes to alternatives, pension funds don’t necessarily need indices, according to Peter Hill, an investment consultant at Hewitt Associates. “Pension funds have started to embrace alternatives even if there is no index coverage.” He notes the well-established trend for pension schemes to access hedge funds through the fund of funds route.

Hill adds: “Where hedge funds are concerned, if daily liquidity is important, or if there is a strong resistance to fee levels, then indices might be more appropriate. But pension funds do not need daily liquidity.”

Goldin, at S&P, says: “When it comes to new strategies, for investors it’s about how to get easy, cheaper access. When it comes to new markets, it’s about the best way to get the most efficient access.”

In terms of strategies, the S&P DTI strategy used by Nomura would be quite complicated for an investor to replicate it alone. For example, the DTI index changes on a monthly basis and rebalances the commodity allocation versus the currency allocation to 50/50 in order to avoid concentration risk. Decisions are also made about whether to take long or short positions. S&P has a lengthy white paper describing how to make these decisions, so it’s a potentially complicated affair for the go-it-alone investor. Employing an index, on the other hand, should allow the strategy to virtually run itself.


But there is still clearly a lot of work to be done when re-balancing complex portfolios consisting of commodity futures and short positions. It is not surprising, then, that investment banks like Nomura, with their in-house trading capabilities, have been enthusiastic users of indices.

Investment banks, in their race to compete with investment managers in the funds sector, have become greater users of indices in recent years. Heinen and Verbeek were recruited by Nomura from Merrill Lynch, along with around twelve other product developers from other banks in 2004 to build Nomura’s funds and equity derivatives business, for example.

Goldin, of S&P, says that ten years ago the biggest customers for index providers were asset managers. But investment banks are increasingly driving the development of alternative-index products because they can leverage their capital market, quant and trading capabilities.

But Hill, at Hewitt Associates, notes certain asset managers can compete with the banks – at least if they are owned by them. “There are an increasing number of products being offered by large asset managers who are usually owned by investment banks that can access in-house capabilities to provide access to hedge fund, private equity or infrastructure investment.”

The banks, however, are also leaders in providing capital guarantees in structured products – and this is where the main battleground lies, but also where indices will help not just the banks and their associated asset managers, but independent asset managers too.

According to S&P, over 500,000 structured products have been issued in Europe since 1995. Over the past five years, the structured product market has grown more than twice as fast as the traditional fund management market (greater than 25% versus 12%).

Competition to provide structured products will only intensify as pension funds and other investors increasingly look for target-led strategies and less volatile portfolios, for which structured products will be depended on more and more.

Structured products often use options to secure their guarantees, and Goldin says that index developers will increasingly look to capture principal protection and non-linear options income into their indices.

Fund managers without the backing of a parent bank may benefit from this. Currently such a manager will have to go to a third-party bank for options coverage in order to be able to create structured products. This might entail paying steep front-end fees. But new indices
that capture non-linear options returns should make the whole process more transparent, and therefore cheaper. ©  2008 funds europe

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