As of the end of 2002 global indexed equity assets totalled nearly $2trn (E1.7trn)1. Clearly, indexing has become a very attractive means of getting equity exposure. Investors have come to use indexing in a number of different ways. Some have embraced passive management and index all of their plan assets, often using broad market benchmarks such as the Russell 3000 Index or the MSCI World Index. Other investors have adopted a strategic core–satellite approach, indexing a core portfolio and using active managers in peripheral strategies. Yet another method investors employ is to use index funds tactically to make active capitalisation, style and sector bets, moving in and out of passive funds for the exposure. These investors spend their time making asset allocation decisions and not worrying about active managers and their performance.
So what is it about indexing that makes it an attractive means of getting equity exposure? The two main reasons are:
q indexing is cost-effective, and
q indexing is efficient.
Nor does it hurt that active managers on average have not been able to beat their benchmarks.

Indexing is cost-effective
Indexing is very cost-effective. The most visible saving is the lower management fee charged by index managers. This will typically be approximately 5 basis points to manage a US equity benchmark and 10 basis points for an international or global equity benchmark. This compares to 45 bps or more in management fees for an active manager – a saving of nearly 80%.
Another reason that indexing is cost-effective is that it tends to have much lower transaction costs. Transaction costs alone can have a very detrimental effect on fund performance. There are two reasons indexing is able to minimise transaction costs. The first is that most indices – and therefore the index funds that track them – have very low turnover. The broad US market Russell 3000 Index had turnover of just 2.75% over the past 12 months; the MSCI EAFE Index had turnover of 8% in 2002. An active manager may have portfolio turnover of 75% or more and incur high transaction costs. This is significant, especially when trading in expensive and illiquid markets. Transaction costs erode performance and can take a big bite out of the alpha, or excess return, that an active manager is trying to produce.
The second reason why many index managers can save on transaction costs is that they are able to trade internally among their index and quantitatively managed funds. Client cash flows and security trades can be crossed internally among portfolios without having to go to a broker, pay commissions and cause market impact. In other words, passive funds are able to minimise their transaction costs by avoiding going to the market to trade.

Indexing is efficient
The efficiency of indexing is very much tied to the cost effectiveness outlined above. Taking the higher management fees and transaction costs of the active manager into account, the active manager has to outperform the benchmark by 80 bps or even much more, just to break even with an index fund’s performance after fees and transaction costs.
The efficiency of indexation is also helpful when it comes to selecting managers and getting asset class exposure. Certainly, an investor must choose an index manager and the appropriate benchmark to track, but the number of managers and strategies is small in comparison to the number of active manager and active fund choices. Finding an active manager can be an arduous, costly task. Greenwich Associates estimates that it can cost a plan sponsor about 2% of assets to fire and hire a new manager. Index funds eliminate the manager problem, and allow investors to focus on asset allocation, a decision that has been shown to drive the majority of a plan’s overall return.
For those investors that still believe an active manager can beat the benchmark, and there always will be some, there is no certainty that the manager will deliver consistent positive alpha.
However, there is also a third way – enhanced indexation. This form of management shares many of the same benefits of indexation but also uses active management in moderation to try to outperform the benchmark, usually taking a tracking error of less than 2% to the benchmark. The difference between enhanced indexation and active management is that history favours enhanced managers, which have, on average, outperformed their benchmarks over three, five and 10 years at a lower risk level than active managers2. This makes selecting an enhanced manager a much easier and less stressful process for trustees and investors compared to the average active selection process. In that sense, enhanced is more like selecting a passive than active manager. Additionally, as enhanced managers keep tracking error to the benchmark low, they aim to make very small bets around the benchmark’s country, sector, industry and stock weights. Importantly, enhanced managers make a more symmetrical range of overweights and underweights compared to the average active manager, which is constricted by the ‘no shorting constraint’ and therefore ‘theoretically’ enhanced managers should be able to achieve far higher risk/reward ratios than their active competitors.
Enhanced managers can also extract the same portfolio management benefits as index managers. Turnover is kept reasonably low (usually less than 50%) and crossing is used to reduce commission, spread and market impact costs. Management fees are also in-between those of index and active managers therefore net returns, after all costs to the investor, are usually above index and the ‘average’ active manager. Another reason why enhanced managers have been able to outperform lies in the fact that most of these strategies seek to be size, style and beta neutral against the benchmark. As a result, enhanced managers are less impacted by the changing winds of the market; it should not matter whether growth or value is in favour, enhanced managers should still be able to beat the market.
Richard Hannam is head of the structured products group at State Street Global Advisors. Simon Roe is senior investment manager in the enhanced equity group

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