Passive Indexing? Enhanced Indexing!

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1 WHITE PAPER March 2015 For professional investors Passive Indexing? Enhanced Indexing! David Blitz, PhD Passive Indexing? Enhanced Indexing! 1

2 Enhancing a passive approach In this note we discuss enhanced indexing, as an alternative for increasingly popular passive indexing. We argue that enhanced indexing is supported by theory and evidence, allows for better ESG integration, and contributes to a liquid and efficient market. We also explain why enhanced indexing is more attractive than some other popular investment approaches. Finally, we note that enhanced indexing is not discouraged from a regulatory perspective. The rise of passive investing Passive investors simply buy and hold the capitalization-weighted market portfolio at minimal costs. This approach has solid theoretical and empirical foundations. The main claim against active management is that, on aggregate, it is a zero-sum game before costs and a negative-sum game after costs. This would imply that low-cost passive investing should ensure a better performance than the average actively managed fund 1. Pioneers such as Vanguard have provided proof of concept for passive investing in practice. Their success has not gone unnoticed, as the market share of passive managers has risen steadily over time, and many large institutional investors nowadays invest large portions of their assets passively. From a career perspective passive investing may also be considered a safe choice, because by pretty much guaranteeing a return close to the index, it does not involve the risk of having to explain a large underperformance to stakeholders. This is likely to happen sooner or later with an active approach, because even the best strategies do not work all the time. But there is even more to say in favor of enhanced indexing We are not denying that a strong case can be made for passive investing, and we acknowledge that cheap passive investing is likely to do better than an expensive active manager selected at random. In this note, however, we argue that the case for enhanced indexing is even stronger, because it is supported by theory and evidence, it allows for better ESG integration, and contributes to a liquid and more efficient market. We also argue that enhanced indexing is more cost-effective than an allocation to alternative investments, and more efficient than the recently popular smart beta approaches based on public indices. Finally, we consider regulatory issues applying specifically to the Dutch situation. 1 See, for instance, Sharpe, W., The Arithmetic of Active Management, Financial Analysts Journal 47 (1991), 7-9. Passive Indexing? Enhanced Indexing! 2

3 Considering all the evidence Passive investors ignore factor premiums Passive investing seems to be supported by the literature on mutual fund performance, which at first sight finds little evidence for the added value of active management. We have to be a bit more specific here though, because these studies typically define active management as the part of the return that cannot be explained by either exposure to the market, or exposure to various established factor premiums, such as size, value, momentum and low-volatility. For example, if a fund beats the market by 2% per annum because of a structural tilt towards the value factor, the entire added value of 2% would be attributed to factor exposures, and zero to active management. Thus, a more accurate summary of the literature is that there is little evidence that active managers are able to add value on top of the significant returns that may be earned with factor exposures. Clearly, the logical implication of this result is not to follow a passive approach which totally ignores factor premiums and just focuses on efficiently capturing the market return. Enhanced indexing gives access to the market return AND factor premiums Here enhanced indexing comes in as a solution. By following an enhanced indexing strategy, investors can efficiently capture the market return and, at the same time, benefit from established factor premiums. This is achieved by taking the capitalization-weighted index as a starting point, and then giving more weight to stocks with favorable factor characteristics and less weight to stocks with unfavorable factor characteristics. With enhanced indexing the individual stock over- and underweights are small and the overall portfolio tracking error is low, i.e. somewhere in the range between 0.5% and 2%. By tilting the portfolio towards established factors, enhanced indexing is designed to put all of the evidence provided by the literature into practice, instead of just some 2. Not only does enhanced indexing make sense in theory, it also works in practice The track record of Robeco s various enhanced indexing strategies shows that the approach does not only work in theory, but also in reality. For instance, our flagship developed markets enhanced indexing fund, which has a tracking error of around 1%, has achieved an outperformance of 1.2% per annum since its inception over 10 years ago, with a positive outperformance in 8 out of 10 calendar years 3. For emerging markets, our low tracking error strategies have also delivered according to expectations. Enhanced indexing is not a free lunch though Of course, enhanced indexing is not a strategy that is guaranteed to deliver an outperformance every year. There are also periods during which these strategies lag the market. In this sense, factor premiums are not different from the equity risk premium, which is also positive on average, but definitely not every year. Over longer evaluation periods this risk diminishes though. Ignoring factor premiums for fear of short-term underperformance is really a missed opportunity, because their reward per unit of risk is typically even more attractive than the market risk premium itself. 2 The low target tracking error does mean that enhanced indexing strategies are not equally well-suited for exploiting each particular factor premium. For instance, low-volatility strategies tend to involve high tracking errors due to their beta well below 1. 3 Source: Robeco Performance Measurement. The fund in question is the Robeco Institutional Global Enhanced Index fund. Data as of end 2014, gross of fees, based on net asset value. The value of your investments may fluctuate. Returns obtained in the past are no guarantee for the future. Passive Indexing? Enhanced Indexing! 3

4 ESG considerations ESG is high on the agenda of investors A growing number of institutional investors wish to incorporate Environmental, Social and Governance (ESG) factors in their investment process. Passive investing is not particularly suitable for this, as the whole idea is to not have any view on individual stocks and just buy the entire market portfolio. This is exactly what we see in the retail space, where Exchange Traded Funds (ETFs) typically follow a broad market index such as the S&P 500 or the MSCI Emerging Markets index. Exclusion policy is not enough Large institutional investors can incorporate some ESG considerations by specifying a list of stocks that should be excluded from the index. Such an exclusion policy is usually not regarded as full ESG integration though, because it only focuses on some of the worst offenders and ignores everything else. Moreover, the customization involved with exclusion may come at the cost of a higher fee, because passive providers can benefit less from economies of scale if each client comes up with a different exclusion list. Another concern with exclusion is that some studies have suggested that it is likely to hurt performance, as sin stocks that are shunned by large groups of investors may become underpriced 4. Enhanced indexing is better equipped for full ESG integration Enhanced indexing is better equipped for full ESG integration, because once you allow yourself to deviate a bit from the index in order to benefit from factor premiums, you may decide to use some of this room for more thorough ESG integration. For example, in all of our quantitative equity strategies we apply a constraint which ensures that the portfolio ESG score is never below the benchmark ESG score, using proprietary RobecoSAM best-inclass ESG assessments. We find that imposing this constraint has a neutral effect on performance, so it can basically be added for free 5. We also offer an enhanced indexing strategy which combines a very strong ESG profile with a low tracking error, called Robeco Quant Sustainable Global Equities. And what about the ESG profile of your asset manager? The ESG discussion should not only focus on the companies one invests in, but also on the asset management firm that does the investing. One could consider, for instance, the assessment of asset managers on the United Nations Principles for Responsible Investment (UN PRI). Another relevant factor could be how pro-actively asset managers strive to incorporate ESG criteria in all the portfolios they manage, instead of merely re-actively in case the client insists. 4 See, for instance, the evidence provided in Hong, H., and Kacperczyk, M., The price of sin: The effects of social norms on markets, Journal of Financial Economics 93 (2009), See also our client note Sustainability integration in Quantitative Equity strategies, February Passive Indexing? Enhanced Indexing! 4

5 Contributing to market efficiency Passive investing is an example of free-riding behavior Blitz (2014) argues that passive investors are essentially free-riding, and assume that other (active) investors have done their homework properly 6. For instance, passive investors are not concerned about buying a stock such as Facebook, with a P/E ratio of around 100 after its IPO. They also feel comfortable with buying Greek government bonds, when the benchmark implies that other investors have also done so. Passive investors tend to assume that the price is always right. Paradoxically, however, if everyone were to invest passively, the result would be a complete breakdown of the link between prices and fundamentals. Liquidity would also disappear, as the capitalization-weighted market portfolio reflects a buy-and-hold approach that requires no trading (apart from certain corporate actions, such as IPOs). So active management is vital, but how can it be reconciled with the notion that it seems to be a negative-sum game after costs? Active management is needed to ensure an efficient allocation of capital From a macro-economic perspective, the added value of active management is not its aggregate outperformance over the market risk premium, which cannot be positive by definition, but to ensure an efficient allocation of capital by setting fair prices. If prices are too high, it is attractive for firms to issue new shares, but investors will make a poor return on them. In other words, the equity risk premium is eroded. If, on the other hand, prices are too low, it is unattractive for firms to issue new shares, and economic growth is hampered. In other words, active investing is needed to ensure an efficient allocation of capital, which is not a negative-sum game but a positive-sum game! Does enhanced indexing offer the best balance? Active investing is often seen as a moral responsibility that comes along with a market economy, just like voting can be seen as a moral responsibility in a parliamentary democracy. An efficient and liquid market benefits everyone, but because this can only arise as a result of large-scale active investing, should every investor perhaps feel obliged to contribute? Enhanced indexing allows investors to capture the benefits of a passive approach, while being optimized for performance, and at the same time contributes to maintaining and further improving market efficiency. 6 Blitz, D., The Dark Side of Passive Investing, Journal of Portfolio Management 41 (2014), 1-4 (invited editorial). Passive Indexing? Enhanced Indexing! 5

6 Cost considerations Costs are under scrutiny Costs are another example of a topic that is high on the agenda of many institutional investors. In this section we argue that enhanced indexing can also be a very cost-effective solution. For this we compare enhanced indexing with two alternative ways of boosting the return of a simple passive equity/bond portfolio, namely an allocation to alternative investments, or the adoption of a smart beta approach. Enhanced indexing can be more cost-effective than alternative investments The literature does not find much evidence that the average private equity fund or the average hedge fund generates true added value, after adjusting for risk and (implicit) exposures to common factor premiums. Allocating to these alternatives only makes sense if one has the skills and resources to identify the best-performing managers 7. These managers tend to be expensive though, charging sizable fixed and performance-related fees. The example below illustrates how enhanced indexing can be more cost-effective. Consider a pension fund with an allocation of 50% to an LDI matching portfolio (fixed income), 40% listed equities (passive) and 10% alternative investments such as private equity and hedge funds. It is not unreasonable to assume that the fee load involved with the alternatives portfolio amounts to over 2% per annum, i.e. over 0.20% at the portfolio level. This means that a portfolio which simply invests 50% in an enhanced indexing equity strategy is cheaper as long as the enhanced indexing strategy involves a fee of less than 0.40%, which should be quite feasible. Moreover, in order to match an outperformance of 1% per annum for the enhanced indexing strategy, the alternatives portfolio should outperform the market index by 5% per annum (after costs!), which does not sound like a reasonable expectation. Enhanced indexing seems to offer a better cost/benefit trade-off. Enhanced indexing is more efficient than smart beta Enhanced indexing is designed to exploit established factor premiums, but so are smart beta indices. Smart beta offers full transparency and fee levels that are probably even lower than for enhanced indexing. Still, the case for enhanced indexing may be stronger. For one, enhanced indexing is optimized for performance, while smart beta indices are designed with simplicity and transparency in mind. Not constrained by this, enhanced indexing can make use of more advanced variables and more sophisticated portfolio construction and risk management techniques. In addition, enhanced indexing offers a stable tracking error, while the tracking error of smart beta indices can vary a lot over time. Also, the transparency of smart beta indices makes them vulnerable to predatory trading, which is much less of a concern for proprietary enhanced indexing approaches. 7 We refer to the Robeco white papers on the added value of private equity and hedge funds (available in Dutch only). Passive Indexing? Enhanced Indexing! 6

7 Dutch regulatory aspects Dutch regulators have recently started to openly question active investing, encouraging investors to seriously consider a passive approach instead. For instance, the AFM supervisory authority takes this stance in its recent white papers 8, while the Dutch central bank now explicitly penalizes pension funds for using active management, with higher solvency requirements in its new FTK regulatory framework. The new FTK for Dutch pension funds contains a new, additional solvency charge for active management of the equity portfolio. Interestingly, an exception is made for equity portfolios that have a tracking error of less than 1%. In this case no solvency buffer is required to limit the operational burden. As an enhanced indexing strategy can be tailored to maintain an (ex ante) tracking error below 1%, this means that such a strategy does not need to involve an additional solvency charge compared with a purely passive approach. Summary Investing in a purely passive manner is increasingly popular. In this note we do not deny that passive investing has its merits, but argue that enhanced indexing may be an even better alternative. First, passive investing focuses solely on the market risk premium, and simply ignores factor premiums for which the literature also finds a lot of evidence. Enhanced indexing does take this evidence into account, as it is designed to benefit from both sources of return. Second, enhanced indexing allows for full ESG integration, whereas passive investors either ignore ESG considerations, or limit their efforts to excluding a handful of the worst offenders. Third, enhanced indexing contributes to maintaining and further improving market efficiency. Finally, we argue that enhanced indexing can be a highly cost-effective solution compared with popular alternative investments, and is more efficient than smart beta approaches designed for transparency and appeal. David Blitz, PhD Head Quant Equity Research 8 Specifically, the white papers De wetenschap over de resultaten van actief en passief beleggen (Science on the results of active and passive investing) and Leidraad actief en passief beleggen in het belang van de klant (Guideline for active and passive investing in the client s interest). Passive Indexing? Enhanced Indexing! 7

8 Important information This publication is intended for professional investors. Robeco Institutional Asset Management B.V. (trade register number: ) has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. This document is intended to provide general information on Robeco s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at Passive Indexing? Enhanced Indexing! 8