What to look for in a

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1 What to look for in a passive manager

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3 Passive management, or indexation, is often seen as a commodity product, where choices should be made on price alone. We do not believe this to be true. Here, we explore points of differentiation between passive managers and aim to illustrate why we believe rigorous qualitative research can lead to better outcomes. In passive management, the primary objective is to track an index, whether it is an index of stocks or bonds. It is often used in a portfolio to deliver broad, low-cost market exposure and, as such, it can be easy to focus on headline costs. However, doing passive management well is more complicated than many people realise and we believe it is well worth spending time researching the nuances of various products and the methodologies being applied. Poor passive management can, for example, lead to higher transaction costs and/or unexpected performance deviations from the chosen benchmark. Good passive management involves focusing on the detail. In Figure 01 we have set out what we believe to be the key criteria for passive managers and expand on each of these criteria below. A common theme that runs across a number of these criteria, is the advantage that accrues from size. Size is no guarantee of quality in an index manager, but it often helps. Indexation, more than any other form of fund management, is a low margin, high capacity product. Competition between managers and the perception of indexation as a commodity means that managers rarely see the kind of profit margins that are seen in other areas of fund management. Therefore, in many of the areas that we highlight, there are advantages of scale, both at the manager and the product level. Investment professionals Indexation, unlike other areas of fund management, does not tend to attract star portfolio managers. However, index tracking requires a specific skill set, so a dedicated and high-quality team can make a lot of difference to the strength of the offering. Experience is an important characteristic, as well as a good understanding of both quantitative risk systems (their strengths and limitations) and more qualitative risk metrics. Depth of team is also important, to ensure a comfortable level of coverage for each portfolio manager. In our opinion, portfolio managers should not have too many different accounts to manage and should also have an understanding of different types of client accounts. Figure 01. Key criteria for passive managers Investment professionals Broad, deep, experienced team Philosophy and insight generation Methods to add value within acceptable risk parameters Portfolio management High quality systems Efficient trading Securities lending policy and controls Firm and team stability Size of the indexation business Opportunity set Size of individual index tracking funds Appropriate fund structures Alignment Low fees and costs A range of ancillary services Strong client service...managers may seek to add small amounts of value to offset cost within acceptable risk parameters, for example by timing trading around index changes. What to look for in a passive manager 3

4 Philosophy and insight generation While the primary function of an index manager should always be to provide returns that are close to those of an index, the art and science of indexation is to hold a range of securities that will track the performance of the underlying index closely, without incurring a disproportionate cost in accessing and holding these securities. Techniques that a manager will employ will vary depending on the index being tracked, the size of the product and the manager s investment philosophy. A large pool of assets generally makes it more cost-effective to hold a greater proportion of the index constituents a manager may be able to offer full replication, where every security in the index is held. A pool that is smaller, or is tracking an index of securities that are more expensive to buy and sell, may be run on an optimised basis, where the manager aims to generate the returns of the index by holding a representative sample. Any kind of sampling is likely to result in higher tracking error or tracking difference than full replication. In addition, managers may seek to add small amounts of value to offset cost within acceptable risk parameters, for example by timing trading around index changes. The best managers will balance total returns after fees against minimisation of tracking error (or tracking difference). Portfolio management High quality systems The nature of indexation management means there is a strong focus on cost and risk. The best managers have systems that allow them to see their portfolios easily, understand what the key risks are and transact efficiently within their defined parameters. Pre- and post-trade compliance checks that are built into the portfolio and order management systems are another important risk mitigation feature. A high level of commitment to buying, building and maintaining these systems is a differentiating factor for the leading firms. While a high specification and easy to use system may seem nice-to-have rather than essential, we believe that these tools materially reduce risk of human error. Efficient trading Almost no index that is tracked, be it in equities or bonds, takes account of transaction costs. Every penny that is spent on transactions, administrative costs, fees and taxes represents a negative tracking difference. All managers should be aware of trading costs, but for indexation managers that often hold large numbers of securities in relatively small proportions and have no alpha in which to hide costs, reducing these is a crucial efficiency. Again, scale can help here, as large managers are likely to have more money moving around in order to match buyers and sellers of a security or units in a pooled vehicle, and are able to negotiate favourable terms with brokers. Some managers have periodic days where they try to encourage all clients to trade, so as to maximise crossing opportunities. As technology and trading venues 4 towerswatson.com

5 continue to broaden and expand with the growth of direct market access, algorithmic trading and dark pools, we would expect to see the best indexation managers leading efforts to drive trading cost efficiencies for their clients. Securities lending Securities lending within the portfolio is an additional method that a manager may use to add return to the portfolio, but it is not without risks. These risks were graphically illustrated in 2008 when many funds had problems with their stock lending programmes, mostly where cash collateral had been reinvested in assets that became illiquid. This caused underperformance and, in a number of cases, withdrawal restrictions. Securities lending programmes in particular should be reviewed to ensure that investors are happy with the risks they bring, looking for details such as: What limits there are on lending What collateral is taken and how it is held Whether indemnification is offered and on what aspects of the process How revenues are split between the manager and the investors and whether that brings conflicts of interest The degree of oversight a manager retains of a programme, if it is outsourced to a third party A good securities lending programme cannot make up for a poor manager and any such programme must be monitored. Done well, we believe it can be a beneficial addition to a good product. However, if investors are not comfortable with a manager s approach to securities lending, non-lending funds should be sought. Firm and team stability As we have noted, indexation, more than any other form of fund management, is a low margin, high capacity product. Where profit margins are low, gaining confidence that the team and systems will continue to be supported by the business for the long term is key. Firms with a large, established product base and a business structure where indexation products are important to the firm have an advantage here. Opportunity set Size of individual index tracking funds Within each index tracking fund, size is almost always a benefit. A large pool of assets can mean a manager can hold more of the securities in the index, but it also gives a broader base over which to spread the (often largely fixed) administrative costs. When funds are very large they can also use this scale to create further efficiencies. A bigger fund is likely to have more buyers and sellers than a smaller one and so may offer opportunities for investors to trade at mid-price (through matching these buyers and sellers together). A large equity fund may also be able to use its scale to earn fees for sub-underwriting new stock issuance (which the fund has to buy as the stock enters the index), and to trade more opportunistically than a smaller fund might be able to. What to look for in a passive manager 5

6 As technology and trading venues continue to broaden and expand with the growth of direct market access, algorithmic trading and dark pools, we would expect to see the best indexation managers leading efforts to drive trading cost efficiencies for their clients. Appropriate fund structures to meet specific client needs There are clearly benefi ts in all types of fund management in offering the appropriate vehicle, but within passive management this can be one of the key differences between products. Different types of institutional investors in various markets have certain tax statuses. To invest in a vehicle that mimics their tax status or offers tax transparency can bring material benefi ts in areas such as withholding tax on equity dividends, for example. This is particularly important as a differentiator for certain categories of client, where the tax savings in an appropriate vehicle can more than compensate for any differences in manager fees a more expensive manager with appropriate vehicles may be a better choice than a cheaper manager with inappropriate fund structures. Alignment Alignment captures a manager s overall commitment to its client base. This may be refl ected in the total costs a client faces when investing and in the quality of service offered. A manager may also demonstrate positive alignment through its ownership structure or through fair distribution of securities lending revenue. Investors who prioritise environmental, social and governance factors may also evaluate managers on their alignment with these values, for example through established programmes of engagement with company management. Low fees and costs As we have illustrated, headline fees do not tell the full story when assessing a passive product. Nonetheless, it is clear that one of the key benefi ts that passive management offers when compared to active management is its low cost. Understanding the total cost involved (fees and other costs) will factor into any assessment. It is important to note the details, such as cut off points on sliding fee scales and discounts offered for holding more than one index product with a manager: typically it is cheaper to fi nd one manager than can offer multiple indexed products, as fees can be negotiated on total assets. A range of ancillary services and good client service Ancillary services are also an important part of the value proposition of indexation managers. The ability to monitor and rebalance a multi-asset class mandate against a benchmark, offer help in transitioning assets in and out of funds and offer currency hedging overlays, are often key reasons for employing a passive manager in the fi rst place. As a low-cost alternative to active management, it is important that the manager provides an effi cient and helpful service and is available to support the client where necessary, providing representatives for meetings and general assistance. Summary Passive management is a fast-growing sector in fund management, as many institutional investors focus on costs and effi ciencies within their funds. It is often regarded as easy and argued that the selection decision should be based solely on fees. Here, we have demonstrated that while price is an important factor, there is a lot more to good passive management than low fees. We believe that broader qualitative due diligence, using the detailed criteria we have set out should be undertaken to ensure that appropriate managers are hired to meet an investor s needs, now and in the future. Further information For further information, please contact your Towers Watson consultant, or Jane Welsh jane.welsh@towerswatson.com 6 towerswatson.com

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8 About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With more than 14,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Towers Watson 21 Tothill Street Westminster London SW1H 9LL This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watson s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. To unsubscribe, eu.unsubscribe@towerswatson.com with the publication name as the subject and include your name, title and company address. Copyright 2014 Towers Watson. All rights reserved. TW-EU March towerswatson.com