The index artists

The past 12 months have posed a new set of challenges for the indexing and exchange-traded fund markets. But as delegates to the Art of Indexing Summit USA in New York heard on October 28, providers are adapting to the changed landscape. Now it is simply a question of convincing the advisers.

Indexing and exchange-traded funds (ETFs) are two investment classes that find themselves in relative ascendance. While other classes such as hedge funds, structured notes and mutual funds have suffered heavy outflows, indexes and ETFs have profited by offering antidotes to some of these investments’ perceived failings in the form of transparency, liquidity, low counterparty risk and minimal costs.

However, the industry has still had its fair share of controversy over the past 12 months, and as panel discussions at the Art of Indexing Summit USA showed, there is still work to be done on educating the investment community.

Keynote speaker Robert Shiller, co-founder of Macro-Markets and Okun Professor of Economics at Yale University, argued that “too many” derivatives were not the cause of the current crisis. “Derivatives are not the problem that got us here,” said Shiller, who co-founded the S&P Case Shiller Home Price Index. “Hedging is the way that we solve problems.” Shiller said that the market crash was the result of a failure to manage risk properly, especially in real estate markets. The solution is for derivatives to be used on a much wider scale to help individuals risk manage their own lives. “Lots of people were in leveraged, undiversified positions and that’s why they are in trouble,” he said.

For savvier investors with the ability to hedge themselves, or who at least at least liked the idea of riding the market fall, one of the most prolific stories of 2009 has been the performance of leveraged and inverse ETFs. In some cases, performance has shown a massive divergence from the expectations of retail investors, who did not realise that the effect of daily compounding meant the products will only fulfil their stated objective for periods of no longer than one day.

Konrad Sippel, head of XTF, indexes and exchange-traded funds at Deutsche Börse, showed how short indexes can still have a hedge value in a portfolio. Using the German Dax equity benchmark index and the Dax Short, Sippel responded to the criticism by showing that in many cases where stock markets had fallen, an equally weighted portfolio containing both indexes usually provided an adequate hedge.

Correlation is the next step. How do you strip it out? And what will the elements be: constituents of an index or asset classes?

During the 2003 war in Iraq, for example, the Dax fell 36.1%, while the Dax Short would have risen 34.8%. It is not always a perfect hedge, said Sippel, but even taking the drag effect into account, there was often only a maximum gap of around 10% between both indexes historically. Equally, current products that aim for weekly or monthly performance rather than daily have “significant problems,” he said.

Other delegates and speakers were divided about the use of the products. “Short and leveraged ETFs helped us a lot in the past year – we didn’t lose any money in the fourth quarter,” said Anthony Welch, co-founder of Sarasota Capital Strategies, speaking in a panel session. “But you’ve got to be active,” he said.

The active-passive debate
Actively managed ETFs are another product development that has split industry opinion. “I feel the same way about actively managed ETFs as I do about leveraged ones,” said Keith DeGreen, chief executive and portfolio manager at DeGreen Capital Management, in another panel discussion. “I end up explaining what the product is not – it’s meant to be a passive tracker.”

The poor performance of many actively managed funds over the past year appears to have severely dented some investors’ faith in fund managers. “Close to 70% of active managers don’t beat their benchmarks,” said Kevin Mahn, chief investment officer at Hennion & Walsh Asset Management and portfolio manager for Smartgrowth mutual funds, speaking on the same panel as DeGreen, indicating that there was little point in underperforming a benchmark and paying less for it.

The active-versus-passive debate is pertinent for index providers, who have been thrown into a positive light by dint of their low cost of access, which has often trumped their expensive mutual fund counterparts over the past year. But this was another topic that split opinion among delegates.

“The research that Russell has carried out shows that active is best in periods of high cross-sectional volatility. The further you move away from zero, the more opportunities there are for active management to succeed,” said Rolf Agather, director of business development at Russell Investments, in a panel session on the merits of the two approaches.

Fellow panellist Mark Sladkus, founder and president at Red Lighthouse, disagreed. “With active, you will always get the market’s performance minus expenses,” said Sladkus. “Some individual managers can outperform, but in aggregate… it doesn’t make mathematical sense.”

Many speakers agreed, saying they would rather use ETFs to run their own active management. One of the main advantages of indexing is the access to previously closed asset classes that it can provide, no matter how obscure they may be.

A recent example of this is dividends, which are becoming increasingly popular as an underlying. “Dividends have been stripped out as an asset class for institutional investors over the past year and will probably hit the retail market in the year ahead,” said Ricardo Manrique, chief executive of Stoxx, the index provider.

“Correlation is the next step. How do you strip it out? And what will the elements be: constituents of an index or asset classes? It will be more relevant to the institutional side, and is perhaps a bit of a stretch for retail investors,” he said. Even volatility remains a challenge. Though vix options are widely traded, there is still a way to go before volatility is established as an asset class.

A more mainstream asset class that came under discussion was commodities, which have remained at the forefront of the indexing business over the past year, as the idea of using commodity provider stocks to gain exposure rather than futures contracts gains traction.

This shift is not necessarily as straightforward as it seems, however.  “There are issues with investing in commodity equities to gain access – you need to look at those equities internally to see how they are playing the commodity,” said David Blitzer, managing director and chairman at Standard & Poor’s. This might mean looking at how a mining company conducts its business, for example.

Commodities were also discussed as a hedge against inflation, which is becoming an increasing concern among investors against the backdrop of recent monetary policy.

As the summit drew to a close, an advisory panel looked at the US retirement industry, specifically 401(k) plans. Given the ageing population of the US, these plans represent a huge opportunity for ETF providers. If the two biggest requirements in products for 401(k)s are transparency and expenses, then ETFs address both of them, said Hennion & Walsh’s Mahn. Yet there are still significant obstacles. “Most record-keeping systems can’t process ETFs. It could be because plan sponsors are reluctant to use new products that they don’t understand, much less the end-investor,” he said.

Other panellists expressed surprise that the products had not gained  more market penetration. “I’ve been in 401(k) fund consulting for 20 years and I don’t tend to find index-based funds there, which is strange because it seems like a good place for them – they track the benchmark so closely and the fees are low,” said Frederick Wright, chief investment officer of Smith and Howard Wealth. Advisers expressed confusion over the transaction costs involved, which further underlines the educational process that providers must undertake if they want to penetrate this segment of the market.