FOR PROFESSIONAL CLIENTS ONLY A PROFESSIONAL S GUIDE TO INDEX INVESTING UNDERSTANDING FUNDS PORTFOLIO CONSTRUCTION DUE DILIGENCE CLIENT SOLUTIONS

Transcription

1 FOR PROFESSIONAL CLIENTS ONLY A PROFESSIONAL S GUIDE TO INDEX INVESTING UNDERSTANDING FUNDS PORTFOLIO CONSTRUCTION DUE DILIGENCE CLIENT SOLUTIONS

2 Contents CHAPTER 1 INTRODUCING INDEXING 2 A brief history Index and active investing Being active about passive Indexing and RDR The how and why of indexing Index tracking CHAPTER 2 TWO INDEXING VEHICLES 7 Traditional index funds and ETFs Shifting paradigm Total expense ratio and total cost of ownership Securities lending Traditional index tracker or ETF? CHAPTER 3 MANAGING INDEX FUNDS 10 Full replication Optimisation Synthetic replication CHAPTER 4 CONSTRUCTING PORTFOLIOS 12 Core satellite investing Recap on asset allocation Multi-asset index solutions Why use a multi-asset index solution? CHAPTER 5 CASE STUDIES 16 Pure indexing Combining index and active funds CHAPTER 6 DUE DILIGENCE 20 Size and scale matter Expand your indexing CHAPTER 7 BLACKROCK INDEXING SOLUTIONS 24 Comprehensive risk management BlackRock Collective Investment Funds ishares ETFs BlackRock Consensus Funds More than index funds of funds A PROFESSIONAL S GUIDE TO INDEX INVESTING

3 Indexing: an important part of client portfolios At BlackRock, we re mindful of the challenges advisers are facing in the lead up to the Retail Distribution Review (RDR). From 2013, advisers who wish to be considered independent will need to provide unbiased and unrestricted advice, based on a comprehensive and fair analysis of the relevant market : this means considering all retail investment products which are capable of meeting the investment needs and objectives of a retail client. In this new world, index (or passive) investing should become of more interest to many advisers and their clients. It s not a new approach, but in the wake of the RDR, both traditional index tracker funds and exchange traded funds (ETFs) tick a lot of boxes being simple, relatively low cost investments that provide returns in line with market indices. Sales figures are already reflecting this trend. Net sales of index tracker funds in the UK reached a record 1.9 billion in 2011, bringing the total AUM held in these funds by UK investors to 39 billion*. Equally, last year saw European domiciled ETFs record net new assets of 14.8bn and this figure may well increase in Recent research by NMG Consulting into adviser product use also revealed that over a third of financial advisers are quite likely or very likely to increase their usage of traditional index tracker funds and ETFs post-rdr. i WHY INDEX? Simplicity Efficiency Transparency Cost-effectiveness QUESTIONS? For further information please speak to your BlackRock Sales Representative or visit blackrock.co.uk However, this doesn t mean that active funds no longer have a place within portfolios. Quite the contrary, combining active and index investment strategies, can not only lower overall costs, it can also enhance returns. For too long debate has been focused on active versus index investments, which rather missed the point. Today in recognition of the value that both strategies deliver it s all about combining active and index strategies. In regards to which type of index vehicle advisers should use either traditional index trackers or ETFs we believe this depends on several factors based on individual client needs. Then just as important is your specific choice of index and manager it s not as simple as it may seem. There are key differentiators between funds and managers, making thorough due diligence essential. So the aim of this guide is to help you better understand index investing, its overall benefits, the different vehicles, and how they can be effectively implemented in your client portfolios. * Source: Investment Management Association (IMA), as at December 2011, investmentfunds.org.uk Source: ETP Landscape, BlackRock Investment Institute as at July 2012 Source: IFA Census NMG Consulting as at June 2012 We hope you find it useful. Tony Stenning Head of UK Retail Business Mark Johnson Head of ishares UK Sales A PROFESSIONAL S GUIDE TO INDEX INVESTING [1]

4 CHAPTER 1 Introducing indexing ALPHA A measure of performance on a riskadjusted basis. Alpha takes the volatility (price risk) of a fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund s alpha. Alpha can also be defined as the abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM). BETA Beta is a measure indicating a fund s historic volatility relative to its benchmark index. A fund with a beta of 1 is expected to move in line with its benchmark index A fund with a beta of over 1 is expected to have a lower correlation with its benchmark. By definition, index tracking funds will aim for a beta of 1. A BRIEF HISTORY First introduced in the 1970s, index investing began with equity tracking mutual funds. Over the past 40 years, the index style of investing has expanded and evolved to cover most other asset classes, and has bred new vehicles, the most successful of them being exchange traded funds (ETFs). Designed in the early 1990s, ETFs have grown and expanded so that in Europe alone over the past decade ETFs have seen a compound annual growth rate of 42.5% ( ). * Today, there are thousands of index funds tracking virtually every global market index. INDEX AND ACTIVE INVESTING Index investing is often defined against another core approach to investing active funds. Index funds are designed to provide investors with market exposure (or beta) by tracking the performance of an externally specified market index. Active funds, on the other hand, seek to outperform their benchmark known as achieving alpha as well as deliver greater returns than cash deposits. By tracking an index, index funds typically achieve diversification and returns in line with market averages, with low management fees. Active funds, while generally higher in fees, have the potential to deliver returns higher than the benchmark through the skill of professional fund managers. Both approaches have pros and cons, so a sensible and increasingly popular strategy is to use both to complement each other in a portfolio. While index funds are a straightforward and inexpensive way of accessing core markets, active funds can be used to access other markets with potential for betterthan-average returns. * Source: ETP Landscape, BlackRock Investment Institute as at July [2] A PROFESSIONAL S GUIDE TO INDEX INVESTING

5 The table below highlights the benefits of each approach. Active Index Potential to outperform the underlying market through research-driven stock selection Low-cost exposure to a broad basket of securities in order to track the underlying market Ability to reduce exposure to sectors that are likely to underperform Broad-based exposure gives diversification Ability to help to limit losses in a declining market Emphasis on diversification rather than finding an active manager who can consistently outperform Ability to provide specialist coverage and knowledge of markets Large choice of specific market exposures ranging from broad to specialist GROWTH OF INDEX FUNDS IN EUROPE, MIDDLE EAST AND ASIA 700,000 2,500 US$ 600, , , , , ,000 2,000 1,500 1, Dec Dec Dec Dec Dec Dec Dec Dec Jun AUM Number of funds Source: BlackRock Investment Institute ETF Research, Bloomberg, Strategist Insight, Simfund 9L, A PROFESSIONAL S GUIDE TO INDEX INVESTING [3]

6 BEING ACTIVE ABOUT PASSIVE Chapter 3 of this guide illustrates some of the different ways active and index funds can be combined in a core satellite portfolio, depending on the investor s individual investment goals, timeframe and tolerance for risk. Once this and asset allocation have been determined, choosing which funds to invest is the next big challenge. While many advisers are used to researching active funds and managers, there can be an assumption that less due diligence is required for index funds. This is not the case there can be significant variances in the performance of index funds, some are much better than others at mirroring their benchmark, and the price of funds should only be one consideration. Chapter 4 outlines some of the key features of good index management. INDEXING AND RDR Index funds have been cited by the Financial Service Authority s RDR as one of the packaged products that advisers wishing to be independent should familiarise themselves with and consider in their recommendations to clients. Index funds such as ETFs are noted as investment tools that can be suitable retail investment products as they are a cheap and transparent way to access the market. While many traditional index funds have commission payments (until January 2013), the ETF structure does not support commission remuneration. So in this regard, ETFs are RDR ready as they fit the new adviser charging model proposed by the Financial Conduct Authority (FCA). This statement has become media fodder, but it s not that simple. Firstly, benchmarks cannot be invested in directly so you can t truly compare active and index funds. And remember index funds typically have a drag relative to the index (relating to fees for example). In any case, by selecting a better-thanaverage manager, investors will have a much better chance of beating the benchmark. And while there s no way of guaranteeing outperformance, looking for managers with a high active risk or tracking error, who may operate in inefficient markets, and holding funds for longer periods should increase your chance of better returns. [4] A PROFESSIONAL S GUIDE TO INDEX INVESTING

7 For too long debate has been focused on active versus index investments, which rather missed the point. Today in recognition of the value that both strategies deliver it s all about combining active and index strategies. A PROFESSIONAL S GUIDE TO INDEX INVESTING [5]

8 The how and why of indexing INDEX TRACKING Index funds that is both traditional index tracker funds and ETFs seek to deliver the performance of a chosen index. They typically do this by holding the index constituent stocks at their index weights, or a representative sample depending on factors such as the size and complexity of the index. So for example, in the UK marketplace one of the most commonly referenced indices is the FTSE 100, a share index of the 100 most highly capitalised UK companies listed on the London Stock Exchange. A fully replicated index fund that tracks the FTSE 100 invests in all companies in that index. This fund buys all the stocks in the FTSE 100 in the same proportion they represent in the index. So if Vodafone accounts for 6% of the FTSE 100 Index by value and a smaller company such as Tate & Lyle accounts for 1%, some 6% of the fund by value will be in Vodafone shares and 1% by value in Tate & Lyle and rebalancing will occur to ensure the fund is consistent with the index. If shares in the FTSE 100 rise in value, so should the value of the index fund. i TRACKING ERROR This is a measure of how closely a portfolio follows the index to which it is benchmarked. For index funds, the closer the tracking error is to zero, the better or more efficient the fund is. KEY BENEFITS OF INDEX FUNDS INCLUDE: 1 Diversification Index funds are made up of a broad portfolio of individual securities. As a result, they are highly diversified and returns are less likely to be heavily influenced by the performance of a single security than would be the case in a more constrained portfolio. 2 Transparency Index funds are highly transparent in their investment objective: to achieve results in line with their market benchmark. They re also transparent in the sense that funds are composed of the securities in their tracking index. 3 Consistent delivery of market exposure Index funds aim to deliver the returns of the chosen market by investing in, and carefully repositioning, the securities that continually reflect the relevant index over time. As a result, an investor who wishes to gain exposure to the FTSE 100 Index can be assured of receiving returns (less fees) in line with the FTSE Efficient building blocks Index funds can provide highly efficient building blocks for diversified portfolios, with stable, low-cost exposure to a given segment of the market. They can be used in the core or satellite of a portfolio. 5 Cost-effectiveness Index funds offer a cost-effective route to diversified market exposure. The average total expense ratio (TER) of index funds is generally lower than the average active fund. 6 Accessibility Both index funds and ETFs are available on platforms, and ETFs are listed on stock exchanges and can be bought and sold via a stock broker. [6] A PROFESSIONAL S GUIDE TO INDEX INVESTING

9 Two indexing vehicles CHAPTER 2 TRADITIONAL INDEX FUNDS AND ETFS The two wrappers are extremely similar both are managed to accurately mirror the performance of an index. However, the fundamental difference is ETFs can be bought and sold on a stock exchange. So put simply, traditional index funds resemble active funds in the way they re bought and sold, whereas ETFs trade more like individual shares. ETFs can be purchased or sold throughout the trading day, while traditional index funds can only be purchased or redeemed according to the dealing cycle set by the fund manager (typically once per day). Hence, ETFs have the specific advantage of intra-day trading. SHIFTING PARADIGM Historical speaking, advisers have appeared to prefer traditional index funds over ETFs, while ETFs have been readily and enthusiastically adopted by large financial institutions. But this paradigm is changing. Retail sales of ETFs are growing every year, so the split between retail and institutional usage in Europe is now 30:70 *. This gap is likely to narrow after the RDR comes into effect and commission on all investment products disappears. ** OPEN FOR BUSINESS Both traditional index funds and ETFs are UCITS (Undertakings for Collective Investment in Transferable Securities) in the UK under the European Union Directive that provides a regulatory framework for investment funds sold to the public in the EU. Like active funds, index funds tend to be open-ended in Europe, helping to ensure that high or low demand for the funds does not affect its market price. Instead the price will be governed primarily by the performance of its underlying index. Another factor supporting the usage of ETFs is that they tend to track a broader range of markets and sectors covering the major indices for stocks and shares, bonds, commodities, plus more niche markets. So as a result of the diverse markets they cover, ETFs are becoming an important tool for portfolio asset allocation. The table below shows some of the key differences between traditional index tracker funds and ETFs. ETF Traditional index tracker Dealing Intraday Daily Buying methodology and administration Resembles shares Resembles unit trusts Exposures Typically offer a wide range of asset classes Typically restricted to core asset classes ** ETP Landscape, BlackRock Investment Institute, July ** ETFs do not offer commission to distributors selling them, unlike mutual funds, which has been cited as o ne of the main reasons why there has not been a broad shift into the vehicles. It s worth noting that ETFs are widely available on UK platforms. A PROFESSIONAL S GUIDE TO INDEX INVESTING [7]

10 TOTAL EXPENSE RATIO AND TOTAL COST OF OWNERSHIP The total expense ratio (TER) is a measure of the total costs associated with managing and operating an investment fund. These costs consist primarily of management fees and additional expenses such as trading fees, legal fees, auditor fees and other operational expenses. As with conventional investment funds, the highest TERs will tend to apply to index funds tracking more specialist indices, such as those following emerging markets. TERs for funds following developed markets such as the UK and US can be very low. But the TER isn t exhaustive. To ensure all charges are accounted for, investors need to ascertain the total cost of ownership (TCO). Alongside the TER, this will include trading and portfolio rebalancing costs, swap spreads (for swap-based ETFs). It will also include revenues that may actually reduce the cost of ownership for example from securities lending (see below). Once all these factors are taken into account, the TCO may be higher or even lower than the TER. SECURITIES LENDING This is now common practice in financial markets. Index funds can make shortterm loans of their securities in order to generate incremental returns for their portfolios. Securities lending aims to benefit investors by providing liquidity for the market, facilitating price formation and helping to ensure that the financial markets operate efficiently. Securities lending is currently topical in regards to ETFs due to their rapid growth in Europe. The attributes of both physical and synthetic ETF structures have been heavily debated over the last few years, with both investors and regulators looking to better understand their benefits and associated risks. Securities lending is applied in both structures and as a result has fallen under the spotlight. Bank of England 2012, bankofengland.co.uk ishares and BlackRock have worked closely with European regulators and industry participants to ensure investors understand the role securities lending can play. We have always encouraged full disclosure of securities lending activity in both physical and derivative-replicating ETFs and ishares has additionally encouraged clearer labelling of ETFs to help investors understand the variety of risks behind each structure. [8] A PROFESSIONAL S GUIDE TO INDEX INVESTING

11 TRADITIONAL INDEX TRACKER OR ETF? When deciding which vehicle is best for you and your clients, some key points to consider are: Does the client require intra-day trading? Do you or your client have a brokerage account? Are your software and administration systems set up for ETFs? Which markets and assets are you looking to include in the portfolio? At a basic level, which approach are you more comfortable with buying and selling unit trusts or individual shares? In some cases it may not be a case of traditional index funds or ETFs both can be used. In Chapter 3, we look at how the two vehicles can be combined in a portfolio. And finally, look very carefully into the cost of each fund the advertised headline price may not represent the full cost of dealing. In thinking about which technique to use and when, the diagram below offers a basic guide. So for example, if you re looking for a short-term investment, ETFs may be appropriate due to their intra-day trading and broad market coverage. However, if you re interested in a long-term core investment, say UK equities, you may consider an ETF, a traditional index fund or an active fund. Any or all of these funds may be appropriate depending on your operational requirements, cost considerations and your confidence in an active manager. Chapter 3 contains more information on how to use and combine different investment vehicles. Holding period Short term Core Traditional index tracker /ETF ETF Satellite Long term Traditional index tracker/ ETF/active fund Active fund/ ETF CORE SATELLITE PORTFOLIOS A core satellite investment approach offers the flexibility to blend different styles of investing and different market exposures. The core forms the foundation of the investment strategy, around which the more specialised satellite investments are added. Core investments can account for 50% or more of the overall portfolio. Either active or index funds can be used in the core. Chapter 3 looks at core satellite investing in more detail. A PROFESSIONAL S GUIDE TO INDEX INVESTING [9]

12 CHAPTER 3 Managing index funds There are two main ways of managing index funds; full replication and optimisation. The technique used generally depends on the market the fund is invested in. FULL REPLICATION The most common (and seen to be the most reliable) approach, a fully replicated fund has exposure to each security in line with the weight it has in the underlying index. For example an index fund tracking the FTSE 100 contains all the securities in that index. Fully replicated funds are seen as the superior method because there s full transparency of the fund s underlying holdings and tracking error tends to be lower because: risk relative to the index is minimised, portfolios automatically rebalance, minimising turnover and trading costs, and it s often easier and more cost-effective to trade a broader basket of index securities. OPTIMISATION However, full index replication may not be appropriate in all markets. For example, for a broad index such as the MSCI World Index, which comprises more than 1,700 stocks from 23 countries, the time, effort and expense involved in conducting the necessary transactions for complete replication could be disadvantageous to the portfolio. As a result index portfolio managers will sometimes use optimisation or sampling techniques. These funds only purchase a sub-set of index components, which has the advantage of reducing administrative and transaction costs. However, these benefits come with the possibility of slightly higher tracking error, as the fund does not hold all the securities in its benchmark. SYNTHETIC REPLICATION Another recently emerged (less common) method of index fund management is synthetic replication, or swap-based ETFs. These funds rely on a swap agreement between an investment bank and the fund provider to trade one stream of payments for another. So for example, if an ETF holds a basket of equities prescribed by the swap counterparty and enters into an agreement to exchange the performance of this basket for the performance of the relevant index, the equity basket itself will not contain all of the securities of the index. Rather, it will hold a selection of liquid stocks while the swap provides the performance of the index. [10] A PROFESSIONAL S GUIDE TO INDEX INVESTING

13 The table below summarises the key advantages and disadvantages of each method. Advantages Disadvantages FULL REPLICATION Tracks index accurately (low tracking error) Full transparency of underlying holdings Easier to rebalance portfolios Can achieve an additional return through securities lending No direct counterparty risk* In some cases full replication can be more expensive to achieve. However, these costs are often outweighed by the cost savings that result from portfolios automatically rebalancing, thus minimising turnover and trading costs. OPTIMISATION More practical for indices with lots of constituents Can achieve an additional return through securities lending No direct counterparty risk* May track index less accurately (higher tracking error than full replication) SYNTHETIC REPLICATION Makes it possible to track hard-to-access markets Swap counterparty may not meet its agreed payments (counterparty risk) Underlying securities may be very different from those in the index Structure is generally more complex (ETFs only) * Securities lending can create counterparty risk. This is the risk to each party that the other will not live up to its contractual obligations. Counterparty risk can be mitigated using over collateralisation and multiple counterparties. Different ETF providers may choose to manage the counterparty risk differently. THE HUMAN FACTOR It s important to note, managing index funds isn t just a case of running sophisticated computer programmes, there s significant input from fund managers. For example, at BlackRock we employ over 200 investment professionals to manage our equity index funds alone. This team includes portfolio managers, strategists, traders and dedicated researchers all of whom have an important role in our equity index fund investment process. A PROFESSIONAL S GUIDE TO INDEX INVESTING [11]

14 CHAPTER 4 Constructing portfolios TIME AND MONEY The RDR legislation requiring advisers to publish their fees places pressure on advisers to demonstrate the value they are delivering for the fee they charge. With this new level of visibility in place, advisers should be weighing up where their efforts are best spent in fund selection and asset allocation, or in spending time with clients. For many, achieving the latter by outsourcing investment decisions and asset allocation may prove easier and more valuable in the long run. There s no getting around it, determining where to invest a client s money is a complicated process that demands significant time, knowledge and resources. So the first question is: are you prepared to undertake asset allocation and construct bespoke portfolios for your clients? If the answer is yes, then we recommend you consider how and where index fund building blocks can be used. Many investors have historically relied on equities and/or bonds to provide most of their desired investment returns. However, with the increased understanding and availability of a wider range of investment opportunities in recent years, advisers have been able to build more effective portfolios that take advantage of a broader set of more diversified sources of return. Indexing, offers an efficient entry point to the traditional investments of equities and bonds, as well as additional asset classes including corporate debt, government bonds, property and alternative assets such as commodities and infrastructure. CORE SATELLITE INVESTING A straightforward way to combine active and index-tracking investments to build a balanced portfolio is to adopt a core/satellite approach. This is based on the concept of splitting a portfolio into two segments the core portfolio and the satellite investments. The core forms the foundation of the strategy, around which the more specialised satellite investments are added. Core investments can account for 50% or more of the overall portfolio. A popular strategy involves putting index funds at the core, and therefore capturing the benefits of low costs and a broadly diversified exposure to the chosen markets or benchmarks. This delivers the market return element of the portfolio, leaving the satellite open for more specialised investments the adviser believes will deliver active outperformance.! However, portfolios can also be implemented in reverse, with active funds at the core, and index funds in the satellite. There are many types of satellite investments, from funds following a specific investment style or investing in specialist markets, to industry-specific ETFs as well as individual securities. Typically, satellite investments are higher risk and more costly than core investments, but not always. For an in-depth look at blending active and index products you can request a copy of the ishares report Blending Insights by calling [12] A PROFESSIONAL S GUIDE TO INDEX INVESTING

15 The table below outlines some of the different core satellite models you can use, and their pros and cons. Traditional index trackers Active funds Core Satellite Pros Cons Traditional index trackers Active funds Reduced cost High diversification Sources of alpha from niche markets and high-conviction managers Greater passive allocation means limiting alpha potential Core Satellite Active funds ETFs Active funds ETFs Pros High diversification Ability to trade intra-day in the satellite ETFs also allow for more granular and precise asset allocation in the satellite Greater alpha potential from the core Cons More active funds can mean a higher overall cost Core ETFs Satellite Active funds ETFs Active funds Pros Flexible and granular asset allocation in the core, with potential for cap, sector and duration tilts Reduced cost Sources of alpha from niche markets and high-conviction managers Cons Greater passive allocation can mean limiting alpha potential Core Traditional index tracker and active fund blend Traditional index tracker and active fund blend Active ETF & fund blend Satellite Pros Cons ETF and active fund blend Ability to place alpha where you know it exists, with beta everywhere else Costs optimised High diversification Flexibility Granularity where required More choice can mean greater complexity A PROFESSIONAL S GUIDE TO INDEX INVESTING [13]

16 KEEP IN MIND Beta contributes much of the risk of the portfolio source it well. If you can source Alpha it improves the risk-adjusted returns of the portfolio, and is worth paying for. Remember asset allocation is by far your most important decision alpha vs beta choices have to be seen within an asset allocation framework. REBALANCING PORTFOLIOS When it comes to reviewing and rebalancing client portfolios ensuring they continue to meet your clients original objectives through changing market conditions using index funds can make the process easier. A portfolio that includes index funds improves the ability to monitor and rebalance the allocations as the underlying building blocks are transparent, liquid and flexible, allowing portfolios to be rebalanced more efficiently. MULTI-ASSET INDEX SOLUTIONS If the process of selecting and investing in numerous active funds, ETFs, and index mutual fund building blocks is too complex or time consuming for the client s needs, there are funds that can do this for you. Many providers now offer multi-asset one-stop-shop index solutions. These funds generally combine equities, bonds, cash and other assets, to varying degrees to achieve desired risk or volatility levels. Asset allocation is achieved through investing in index fund building blocks. Hence, these pre-packaged multi-asset index solutions can provide an all-in-one transparent and costeffective way of accessing investment returns from a range of asset classes and global markets. Multi-asset index funds can also be used as the core of a portfolio, leaving room and budget for other funds in the satellite. However, as with all investment products, the devil is in the detail. While many of these multi-asset index solutions are as they say: simple, diversified and low cost, it s important to fully understand how they re managed and which funds they invest in. [14] A PROFESSIONAL S GUIDE TO INDEX INVESTING

17 WHY USE A MULTI-ASSET INDEX SOLUTION? 1 Diversification As the name suggests, multi-asset index portfolios provide access to a range of asset classes, and potentially different sectors and geographic regions. 2 Simplicity Most multi-asset index funds are designed to be simple and transparent investment solutions for all types of investors. 3 Efficiency Ready-made model portfolios allow you to provide swift and efficient investment recommendations for certain clients. 4 Cost-effective Multi-asset index solutions are generally priced lower than active funds due to their underlying index vehicles. A PROFESSIONAL S GUIDE TO INDEX INVESTING [15]

18 CHAPTER 5 Pure indexing Case study: Bloomsbury We have three criteria we apply to each client: First we run a cash flow projection for every client that tells us the market return they will need. Then we do a psychometric test to establish the level of risk with which they are comfortable generally, people will go with what feels safer. Finally, we look at how much risk can they afford to take what is their resources/liabilities balance? We then compare and discuss this with clients and this becomes the basis for agreeing their portfolio. GOING AGAINST CONVENTION Robert Lockie is a partner at Bloomsbury financial advisory, a firm focused on clients with 1million or more to invest. The group uses index funds in client portfolios, believing this is the most simple and effective approach portfolio management. We only use pure index funds (as in funds whose purpose is to track an index as closely as possible) when there is no better alternative, as it is well documented that other market participants can take advantage of any investor, such as an index fund manager, if it is evident that they will need to make particular trades at particular times. Conventional index tracking is thus sub-optimal as they can find themselves overpaying for assets they purchase and receiving depressed sale proceeds from those they sell as others, who do not have such constraints against them. We therefore prefer to use passive funds (i.e. those where the components are based not on predictions as to what will do well but which are selected to provide a diversified and efficient representation of the underlying market). These are sometimes described as pure asset class funds as they are intended to provide exposure to the asset class (UK equities, short-dated bonds, emerging markets equities etc.) without being constrained by the need to track a published index. Where pure asset class funds do not exist for an asset class that we wish to own (e.g. real estate), then we use index funds. [16] A PROFESSIONAL S GUIDE TO INDEX INVESTING

19 In client portfolios the split between bonds, equities and cash driven entirely by the client circumstances. Portfolios are regularly rebalanced we reduce exposure to those asset classes that have risen and increase exposure to those asset classes that have fallen, forcing them to buy low and sell high. As a group we reject tactical asset allocation it s market timing and that s not easy to do. For example, if you d read the headlines a couple of years ago, who would have believed that the US market would have done so well? If you do predict prices, everyone else is trying to do it too it s all going round in circles. Overall, we believe in long-term, properly and effectively-diversified portfolios that will serve investors through different market conditions. WHY WE USE INDEX FUNDS Before joining Bloombsbury I d been using model portfolios that contained both index funds and actively managed funds. My experience was that these portfolios took a lot of time to research and some of that work was ineffective. There wasn t a reliable means of uncovering funds with a good likelihood of outperforming with any consistency. I tried a variety of methods, but the same problem kept coming up managers don t tend to stay in the same place. Managers are human beings and their interests are not necessarily aligned with those of the investors in the fund. They are employees of a company and are therefore subject to certain pressures. There was also the risk of style drift. I was drawn to index funds by academic research that showed the key difference for investors in the long-term was the broad split between asset classes cash, bonds, equities etc. Security selection and market timing account for a relatively small amount of the difference in performance between portfolios. As a group we took the decision that it wasn t worth the effort we were expending on finding funds that could deal with the stock-selection and market timing bits when it was a relatively small part of overall returns. We felt it was not what clients seemed to value. We believe in the maxim you get what you don t pay for. In other words, costs are vital for long-term investors. All investors get the market return, some will get more and some will get less but I m not relying on the view that I m necessarily smarter than the market. WHAT TO LOOK FOR IN AN INDEX FUND We seek out low-cost, efficient funds to provide diversified market exposure. We overweight exposure to those risk factors where there is substantial evidence for long term returns that are higher than the market as a consequence of the higher risk. We re asset managers as well as financial planners. Our view is that the planning has to be the starting point and the asset management flows from that. Clients want the relationship more than anything, much more than they want to ensure that they have under-performed or out-performed the market. It s all about whether you ve done well relative to your goals and risk tolerance. A PROFESSIONAL S GUIDE TO INDEX INVESTING [17]

20 Combining index and active funds Case study: EA Solutions Minesh Patel is a director at North London based EA Solutions Ltd and has been an investment adviser for 10 years. The group specialise in pensions work, including annuity purchase and phased retirement and use a blend of index and active funds to build portfolios for their clients retirement solutions. Asset allocation is the core of our proposition and we determine this for each client by assessing their tolerance for risk. To assess a client s risk levels we use risk questionnaires and some stochastic modelling. However I don t think this is a perfect way of determining overall risk as risk questionnaires tend to be driven by outcomes therefore I only use it as the underpinning for a portfolio. We personalise by looking at the experience of the last five years and judging their response to that. Everyone says they can tolerate risk, but not everyone truly understands what that means. Say for example I have a client who is 55 with 1 million to invest. In many cases, this would mean they should be substantially weighted to equities, but we have lots of clients saying they want to keep very low risk with capital preservation far more important. Therefore we will manage a substantial proportion of their portfolio in cash and then have a proportion that we allocate to a risk-modelled asset allocation. My experience is that the security of cash and the lower volatility it brings is a great comforter. We don t use tactical asset allocation much. We re yet to be convinced that it can add a lot of value in the long-term. Relatively recently, we tried to take some tactical positions through single country funds and we found it didn t work. For example China underperformed when it was least expected to. We ve made some recent changes to our portfolio management strategy as the past few years have made us focus more on tolerance for loss and the downside. The downside potential is now more intrinsic to what we do. CORE SATELLITE PORTFOLIOS When we build a fund for a pension, the bulk or core of that will sit in index funds. Because of the long-term time horizon, cost is very important. The satellite funds will be the dividend-producing funds. We haven t tended to be a great supporter of fixed income index funds. We believe that active fund managers can add value in that area and have been happy holders of strategic bond funds, for example. The quality of fixed income managers is good; and investors can get good performance at a reasonable price. We also tend to use fixed income to de-risk parts of client portfolios and we use active funds for more inefficient parts of global equity markets, such as emerging markets. [18] A PROFESSIONAL S GUIDE TO INDEX INVESTING

21 WHY WE USE INDEX FUNDS I looked at several academic studies and decided being active in core markets, such as Europe and the US where information flow is efficient, was not necessarily a productive approach. I felt active fund managers were not adding value consistently in these markets. However, I do feel an active approach is worth employing for areas such as global equity income and` UK equity income. Index funds are particularly good for the growth part of portfolios, where managers don t consistently outperform the benchmark. Cost is also an important consideration. When you bear in mind that the lower cost index funds charge around 0.25% or even lower this is a big driver for us. Ultimately, the total cost has a significant impact over the long-term. WHAT WE LOOK FOR IN AN INDEX FUND I look at the cost and tracking error when selecting index funds. That said, there doesn t tend to be much variance in the tracking error and I question whether the whole debate is that significant as the difference may be marginal. I prefer to use ETFs in core markets due to the variety and competitive pricing. A PROFESSIONAL S GUIDE TO INDEX INVESTING [19]

22 CHAPTER 6 Due diligence is key Whether you decide on a traditional index fund, an ETF, or both, due diligence is vital. The first step is to evaluate the provider. SIZE AND SCALE MATTER Unlike active investing, where fund selection is based on manager insight and stock-picking abilities, choosing between index managers is all about execution capability. In this respect, the size and quality of the manager is extremely important. Larger providers have more assets and hence better leverage when negotiating market trades. These providers can also access significant economies of scale and global markets with the ability to trade cost-effectively and cross security positions internally (saving bid/offer spreads and transaction costs). This helps to ensure low operating costs and tracking error. Aside from size, there are several other key differentiators between index providers. These include: 1 Trading costs Minimising trading costs is a key component of negating the difference between index-based strategy returns and benchmark returns. While index funds incur trading costs by their very nature, it s important to understand that index providers exclude any trading costs when calculating index valuations. Good providers minimise trading costs by crossing client orders and security trades internally, and by tightly controlling external trading. 2 Index events management Index changes and corporate actions require careful management to take advantage of potential opportunities to minimise costs around the event. When navigating these events, index managers should aim to track the index in line with investment objectives, minimise the impact of potential price distortions and add value where appropriate. Providers should monitor trading conditions closely and continue to design risk-controlled strategies to improve returns where possible. 3 Risk management A good index provider has sophisticated risk management systems designed specifically for managing index funds and mitigating investment and operational risks. [20] A PROFESSIONAL S GUIDE TO INDEX INVESTING

23 4 Corporate governance Robust corporate governance structures and processes can help to protect and, ultimately, improve long-term returns to investors. A strong corporate governance team actively monitors corporate governance issues, votes on the holdings for which we have been given authority and engages with securities issuers. 5 Securities lending Securities lending programmes can add value to index-based strategies in many ways. A close integration of securities lending and portfolio management offerings, collateral management services and continual enhancements to the technology and risk management systems underpinning index strategies, should help deliver more consistent returns with reduced risk levels at lower cost for investors. Providers should have dedicated material available that details securities lending. INDEX PROVIDER CHECKLIST Large scale operator Track record in index portfolio management Dedication to providing servicing support to advisers and investors Broad range of funds Competitive pricing Dedicated research teams Commitment to product development IF SECURITIES LENDING IS TAKING PLACE These are the questions you should ask. Is there an independent oversight? How are counterparties selected and monitored? How is the collateral framework determined? How are over-collateralisation levels determined? How are operational risks mitigated? How are returns generated? How are fees shared between the lender and the fund? How do generated returns compare to the broader market Securities Lending returns? Is information about returns, over-collateralisation levels and amount on loan in a specific fund publicly available? Can collateral holdings be monitored regularly? Is the collateralisation framework clearly disclosed? As you can see from the list above, there are numerous opportunities for an experienced asset manager to add value in passive investing, but doing so consistently requires managers to have robust processes and extensive expertise. Evaluating the provider is only the first step. It s important to then examine the product structure, costs and performance record. The tables overleaf list the key questions you should ask. A PROFESSIONAL S GUIDE TO INDEX INVESTING [21]

24 Evaluate the fund Reference index Management structure Is this the most appropriate index for your needs? Do you fully understand how it s constructed? Does the fund use full replication or optimisation? Does the provider publish full details of the fund holdings and how often? What is the TER? Costs What is the TCO? Is this data publicly available and updated frequently? What is the fund s tracking error over different time periods? Performance How do these compare with similar index funds? Is detailed performance data easily available? Where is the fund domiciled? Domicile and regulation Securities lending What is the level of regulation in the domicile? Does the fund qualify as a UCITS fund? Does the provider look to improve upon UCITS requirements? Does the provider lend out its securities to generate additional revenue is this passed on to investors? What percentage of securities in the fund is lent out? Who does it lend to and what collateral does it receive? For ETFs, there are additional factors to consider: What is the fund s daily trading volume? For more information on selecting an ETF, please refer to the ishares brochure Four steps to ETP Selection, available from the ishares website uk.ishares.com Liquidity Counterparties and collateral (synthetic ETFs only) How have buy-sell spreads trended in different market conditions? How many market makers/dealers does the fund trade through? Are swaps set up with multiple counterparties or only one? Is there a policy for acceptable counterparties? What is quality and liquidity of collateral is the ETF over collateralised to reduce risk? Are collateral securities legally held by the ETF or only pledged in a segregated account? [22] A PROFESSIONAL S GUIDE TO INDEX INVESTING

25 EXPAND YOUR INDEXING The past decade has seen index funds become an increasingly important feature of the investment universe. As markets have become increasingly volatile, the simplicity, transparency and lower cost of indexing have made this approach more appealing. The sheer number of different index funds on offer can also facilitate access to an unprecedented range of markets, strategies and asset classes. With new indices and asset baskets being created in response to demand, this breadth of choice is only set to grow. But it is important to understand and appreciate that all index funds are not the same. Their structure and therefore their level of risk and complexity can vary enormously. The quality of performance, the level of cost and the ease of traceability also differ from fund to fund. Index funds may be easy to implement and maintain in client portfolios but advisers still need to take the time to conduct the same depth of due diligence they would with any investment fund. Equally, with more and more organisations looking to participate in the fastgrowing global index market through mutual funds, ETFs and passive multi-asset funds advisers must be sure that their chosen fund provider can demonstrate the expertise, stability and commitment they expect of an investment partner. i MORE INFORMATION? BlackRock broker.services@blackrock.co.uk blackrock.co.uk ishares info@ishares.co.uk ishares.co.uk Finally, any adviser whether you re looking to remain independent from 2013 or not should in the interest of their clients, have a full understanding of all the index investment solutions open to their clients. We hope this guide has provided a useful introduction. EXPLORE INDEXING THROUGH THE BLACKROCK ADVISER CENTRE For more information on index investing and how funds can be used in your clients portfolios please visit our Adviser Centre at blackrock.co.uk. A PROFESSIONAL S GUIDE TO INDEX INVESTING [23]

26 CHAPTER 7 BlackRock indexing solutions BlackRock s experience of managing index strategies stretches back many years. In fact, we pioneered the first institutional index strategy in the 1970s, and are now one of the world s largest providers. In December 2009, with the purchase of Barclays Global Investors (BGI) and its ishares platform in December 2009, BlackRock acquired the world s largest and most sophisticated ETF provider. WHY BLACKROCK? Complete index offering across all market asset classes plus vehicles Disciplined approach focused on managing return, risk and cost Exceptional client service tailored to each client s needs Strong operational technology platform COMPREHENSIVE RISK MANAGEMENT A disciplined investment process and rigorous bottom-up approach to risk management is an essential component of providing clients with the best riskadjusted return potential. We believe investors should approach indexation on a total performance management basis, enabling a more structured balancing of the risks, returns and costs involved in portfolio performance. Index-based portfolio management should be more than mechanically buying and holding the constituents of an index. Effective investment strategies are likely to involve extracting optimal value from trading and managing index events while ensuring that tracking targets are met consistently. BlackRock and ishares use risk systems specifically designed for index funds, with controls at each step of the investment process. Investment risk is closely monitored by portfolio managers through our proprietary portfolio management system. Traders ensure that execution risk is minimised by routing trades to appropriate trading venues. Operational risk is mitigated by straight-through processing and rigorous back office processes. Understanding that risk management is on-going and that new challenges develop as markets evolve, we allocate substantial resources to continuously enhance our technology and analytical capabilities by building on the insights we gain from the trillions of client and third-party assets we manage. [24] A PROFESSIONAL S GUIDE TO INDEX INVESTING