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Supplements » ETFs Report 2013

ENHANCED INDEX MANAGERS: When deviation is good

AirplaneEnhanced index managers say they are attracting investors who want an alternative to active funds and a relatively lower risk means of gaining equity exposure, finds Judith Evans.

Amid the vogue for “smart beta” funds, fuelled by an appetite for cheap low-risk vehicles, managers are hoping to see a corresponding surge in investment in enhanced index funds.

They say investors fleeing fully active funds are moving into enhanced index offerings, which seek to slightly outperform their benchmarks through an element of active management, but are still fairly constrained when it comes to risk.

One provider, JP Morgan Asset Management, is reporting record inflows into its Global Research Enhanced Index fund this year, with $2.6 billion (€1.9 billion) added to the end of September.

“We believe what is behind this is the fact that the market has polarised,” says Beltran Lastra, lead portfolio manager on the JP Morgan fund.

“In the global core equities space the market is moving into passive funds or alternatives to passive. Or, on the other hand, [the market is moving] into global unconstrained funds where you give the keys of the car to the manager and hope for the best.”

Needless to say, Lastra is no fan of the latter arrangement. His fund is region-neutral and sector-neutral within each region, and country-neutral plus or minus 2%.

It has a total expense ratio (TER) of 0.4%, in contrast with an average TER for actively managed funds of about 1.6%.

The fund tracks the MSCI ACWI index (since 2010, when it switched from the MSCI World) but uses a large number of small active positions to target returns of 0.75% to 1% a year above the benchmark.

“Since we started the fund, the world market has gone up in total by 91%, but the fund is up 107%,” says Lastra.

The fund’s strategy avoids seeking to make big calls about the direction of the global economy.

“We don’t try to think about where the world is going to be next year – we try to think about what is our investment insight,” Lastra says.

Gideon Smith, Europe chief investment officer at AXA Rosenberg, says investors have been moving into the company’s enhanced index vehicles, which include the Pan-European Enhanced Index Equity Alpha Fund, as a low-risk way back into equity markets after the post-2008 turmoil.

The range currently has more than €1 billion in assets under management, while the pan-European fund has a TER of 0.79%.

“Over the past year or so, the market has seen flows coming back to equities, investors who were perhaps burned in the past few years. They’re feeling that now is the time to return,” he says.

AXA’s European fund, which tracks the MSCI Europe index, uses a quantitative process to take positions but places constraints on different types of risk, including country and industry.

“Normally, when I build a fully active portfolio, I will only buy stocks that I think will outperform. In an enhanced index fund, you do allow yourself to buy stocks that you think are less attractive, but you hold it underweight for control purposes,” Smith says. “I recognise that there’s risk in not holding it.”

He says that investors may be attracted to the fund because “although it has active risk, it has low total risk”, helping to keep down risk levels across a portfolio.

Like Lastra, he says there is strength in avoiding being driven by macroeconomic issues.

This “protects us when markets ignore our particular interest, which is earnings growth”, he says.

For example, he adds: “In the first quarter [of 2013], when market volatility went up, people became concerned about Greece and the future of the European Union. But in the long run, it’s earnings that matter.”

Like AXA Rosenberg, Invesco Perpetual uses a quantitative process to select its overweight stocks for enhanced index funds, including the £251.35 million (€294.82 million) Global Ex UK Enhanced Index fund.

Tracking the MSCI World Global ex UK net return index, its active strategy is based on valuations, earnings momentum, price trends and management action. It has an annual ongoing charge of 0.38%, plus an entry charge of 5%.

Like many funds that add an active element to passive tracking, the Invesco fund aims, in part, to compensate for overvaluations in indices weighted by market capitalisation.

Such weightings can mean that an overvalued stock’s contribution to the index increases as its value rises, compounding the problem.

“People hang on to losers and sell winners – companies tend to do well at a stretch and poorly at a stretch. When you’re looking at earnings momentum, companies that are doing better than expected continue to do better than expected. That’s human bias,” says Michael Fraikin, head of Invesco’s portfolio management team.

Lastra says: “At the peak of the internet bubble, the vast majority of the growth in the MSCI World was driven by that sector. That’s a lot of risk concentrated in one industry.

It doesn’t pass the common sense test.”

The attempt to compensate for market weightings is also a feature of smart beta funds, which aim to deliver a better risk-return trade-off than funds which track traditional indices.

HSBC Asset Management is launching a range of these funds, which instead of tracking an existing index will follow a series of new, tailor-made “economic scale indices”.

The benchmarks, rebalanced twice a year, seek to represent the fundamental “economic footprint” of companies rather than their market capitalisation. The funds will passively track their indices.

Running since June 2012, the indices include global, emerging markets, Japan, Asia Pacific ex-Japan, the UK, the US, and Latin American. The emerging markets fund has been launched, with the others soon to follow.

The firm anticipates a move towards alternative index funds, especially among institutional investors, over the next three to five years.

The range is designed to complement HSBC’s range of traditional passive funds, says head of distribution Phil Reid, after “demand for the traditional passive range increased exponentially”.

However, managers caution that both the enhanced index and smart beta labels can in certain cases “cover a multitude of sins”, in Smith's words. “Sometimes people just buy the index and use a few derivatives to improve that.”

“There’s debate as to whether smart beta funds are indeed active or not – in some cases they take more active risk than even enhanced index funds do.”

Another factor to bear in mind is that, with fees higher than those of a straight tracker, enhanced or smart beta funds must outperform enough to compensate for their annual charges.

On the other hand, Fraikin says investors are reassured by knowing they can tell quickly how successful an enhanced index fund is following its benchmark, amid growing awareness of the unpredictability of some fully active funds.

“With an enhanced indexation fund, it is much easier to tell what the skill of the management is compared with a highly active fund. If there is a huge tracking error [in an active fund] you won’t be able to address it with any certainty for a long time, whether it is skill or luck,” he says.

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