February 2008

EXECUTIVE INTERVIEW: Watson Wyatt: Index management to rise

A thought leadership group within Watson Wyatt expects a dramatic rise in index management, Roger Urwin, global investment head, tells Nick Fitzpatrick 08_02_roger-urwin.jpgInvestment managers that look to Watson Wyatt, the large global investment consultancy, as a gateway to new business would do well to dust down their index products. This is because index investment is on Watson Wyatt’s agenda, having been put there by the firm’s potentially trend-setting Thinking Ahead Group (TAG). Watson Wyatt established TAG in 2002 to exercise a thought-leadership role among institutional investors, such as the firm’s numerous FTSE 100 pension fund clients. A number of initiatives have flowed out from the group but recently TAG has tapped into the broad disappointment felt by investors about alpha products sold to them in the last few years by mainstream asset managers. Roger Urwin, Watson Wyatt’s global head of investment consulting, who also heads TAG, says: “TAG is interested in how investors can get access to good market returns but for lower fees than those charged by alpha managers, and we foresee a major review of investment ideas that will move the industry towards complex beta strategies.” Watson Wyatt has already worked on fundamental indices, which are designed to achieve “beta prime” returns. Saying he expects that beta prime will be “big”, Urwin adds that the investment world is about to be “overrun” by new indices. Yet it is a funny turn of events that Watson Wyatt’s forward-thinking TAG group is shining a torch on index-related products. The firm established TAG, at least partly, to help mainstream investors identify and work with new asset classes that were proliferating at the turn of the century, such as hedge funds and private equity. The firm is now a major advisor to pension schemes on derivative transactions. Yet prior to this diversification of products, many pension funds invested in a relatively small number of vanilla strategies – with passive indexation chief among them. It seems that the product cycle is going full circle, but whatever the case may be, Urwin is in little doubt that the spur for this new wave of indexation is the disappointment at returns from some mainstream alpha asset managers. “The work on indices that we are seeing is connected, I think, with the disappointment at alpha returns [by mainstream managers],” he says. But Urwin indicates that he thinks mainstream managers do not necessarily always make poor active managers. Moreover, they manage their clients’ expectations wrongly. “A lot of the marketing around alpha funds is aspirational, but it’s hard to sustain the kinds of returns they talk about. Managers have to manage their client expectations better.” Urwin adds: “We think asset managers have over-proliferated their product lines. Our manager research has increased as a result, but though we might tell an investment manager that five out of their 100 products are great, they will still market all the others anyway. “Managers are having a tough time of convincing their clients about alpha, and of course there is a fee element to this too.” Hedge funds are not immune from some criticism though. “Investors are more disappointed with mainstream alpha managers, which is interesting because hedge funds also do not always deliver pure octane alpha. Beta is significant in some of their returns. “In some ways I’m surprised that people aren’t more disappointed with hedge funds, particularly given how much they cost. Hedge funds have done well, but they are expensive.”

If a new form of indexation is a cheaper alternative to mainstream alpha, what is the likelihood that TAG could help establish it on a wider industry agenda? Urwin describes TAG as a “trend incubator” and believes its influence has been significant. “TAG thinks of trends first, and they then tend to become common currency. For example, we evolved risk budgeting, which is now a best practice model. We also developed long-term mandates four years ago and we did a lot of work in fundamental indices well before the indices were out.” TAG was formed by Urwin and Tim Hodgson, a senior investment consultant at Watson Wyatt. “We needed a thought-leadership group, which would help identify where new asset classes were coming from. Alternatives were just a small part of the allocation back then, but they are now much bigger, of course. “Tim Hodgson wanted to look at issues he felt passionate about and I wanted to play a role in the group that was more than just about the management of it. I now spend about a third of my time with TAG.” A group such as TAG is a useful intellectual tool when, like Watson Wyatt, the aims of the business are to work with the brightest investors across the globe. Watson Wyatt has not been slow to notice the growing influence of sovereign funds – the national wealth funds (some of which are in fact pension funds) out of Sweden, Norway, the Middle East and other areas.  Urwin says: “We’ve been thinking a lot about sovereign funds. They are new and exciting and they represent the pioneers in investment.” Watson Wyatt has picked up clients in this sector over the last three years, including Australia’s Future Fund. “We are interested by their governance. Pension funds have a large decision-taking structure which is not streamlined to deal with the fast markets that we inhabit. They do what I call ‘calendar-timing thinking’ because trustees typically only meet every quarter. Sovereign funds tend to have their own CEO, and they have a mission statement, which is characterised by investment excellence. These are ways in which they gain a competitive advantage, but they also have other advantages, such as not being hampered by the same accounting pressures that pension funds are under.” Watson Wyatt, says Urwin, intends to work with institutional funds that are smart and looking for value-adding consultants. “The sovereign funds are among the smartest and they are inevitably part of our target market.”
Sovereign funds are also big, just like the majority of Watson’s clients. But the beta-prime concept is also something that smaller funds can apply. “A better passive strategy is better for smaller pension funds too,” he says. “I call it the ‘democratisation of investment management’, whereby some of the best ideas in the active investment management industry can be put into indices and sold more cheaply.” The cost of a fundamental index management product is low, even as low as ten to 20 basis points, he says.
By way of example, Urwin says the investment ideas that are factored into the new indices have made it possible to benefit from the emerging wealth effect of China and India in a way that does not just track the macro factors. Also, he mentions indices that take a company’s carbon footprint into account.

Forward thinking
Urwin also says there is a lot of forward thinking taking place around indices in the realm of exchange-traded funds (ETFs). Coincidentally perhaps, Watson Wyatt appointed Chris Sutton to TAG last year. Sutton had previously been a CEO with Barclays Global Investors’ ETFs division, iShares. Also coincidentally, last month the TABB Group, a US research firm, said that active fund managers stand to lose approximately $12bn (e8.17bn) a year in potential management fees due to increasing flows to index-based products such as ETFs. Tabb Group said the appetite for index-based funds is nearly “insatiable” and that they pose a “serious danger” to the active management community. Urwin says: “Passive is going through a reawakening that not all indices are born equal. In my mind, it is going to be big.” With this in mind, investment managers might do well to form their own Thinking Ahead Group. Urwin says: “The business application of TAG is that it gives us and our clients first-mover advantage, and for funds that have this kind of resource it is very valuable. “Perhaps there should be an equivalent of TAG within investment management houses.” © fe February 2008

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