More public plans make shift

Public pensionN executives are accelerating a move into indexed assets in the face of disappointing returns from active managers and to get a better handle on their risks.

Chad Rakvin, global equity index director at Northern Trust Global Investments in Chicago, said he thinks that the trend toward passive management will continue at least into the second and third quarters of this year.

“I think it’s a reaction to plans wanting to quantify their risks,” he said. “They came to the conclusion that they underestimated the risks some of their managers were taking.”

The trend will include “broader, deeper moves into overseas equity markets, particularly developed international small-cap and emerging-market small-cap stocks,” Mr. Rakvin said.

Russ Ivinjack, principal at consultant Ennis Knupp & Associates Inc. of Chicago, also said that he expects broad moves into international equities and fixed income.

Public-employee pension funds already have begun moving hundreds of millions of dollars into passive strategies. Public pension plan officials have argued that many active equity managers track their benchmarks too closely and their returns often don’t justify the higher fees they charge.

David Bauer, a partner at Casey Quirk & Associates LLC in Darien, Conn., said that some plans on the corporate side also are moving to indexing to reduce costs, but added that he isn’t seeing a wholesale shift from active management.

“There may be some plans that look toward indexing because they don’t want to lose the beta,” he said.

“This is an industry of hope. The spread between what sponsors need in terms of a return and equity beta don’t match; you have to hope and believe there is someone who will add value, other than what the market will give them,” Mr. Bauer said.

Officials at the $8 billion Employees’ Retirement System of Rhode Island in Providence approved changing its equity portfolio to 80% passive and 20% active, from the 20% passive and 80% active model followed previously.

As a result of that switch, executives are reviewing the fund’s six active equity managers to determine whether they are adding value, either through returns or downside protection.

“We don’t want [active] managers that stick to the index,” said Ken Goodreau, the system’s chief investment officer. “In that case, we can just follow the index.”

The fund’s active equity managers are The Boston Co. Asset Management LLC, Goldman Sachs Asset Management of New York, Mondrian Investment Partners Ltd. of London, NorthPointe Capital LLC of Troy, Mich., Pacific Investment Management Co. of Newport Beach, Calif., and Wellington Management Co. LLP of Boston, Mr. Goodreau said.

Last month, the fund hired State Street Global Advisors of Boston. Mr. Goodreau said SSgA wasn’t hired for a specific mandate, but so it would be in place in the event that the system terminates any of its active managers.

In addition, the C$120.1 billion ($95 billion) Caisse de Depot et Placement du Quebec, Montreal, transferred about C$5 billion in international equity to passive strategies in November. In a statement at that time, Caisse officials said: “The returns obtained to date do not justify the greater effort required for active management, as opposed to an index-based approach.”

Caisse spokesman Maxime Chagnon didn’t return calls requesting more information.

PROOF IN PERFORMANCE

Endorsement of the pension funds’ moves to indexed assets can be found in performance.

The median actively managed large-cap equity manager lagged the Russell 1000 Index last year by 1.05 percentage points, returning -38.65% (after fees) to the index’s -37.6%, according to data from Morningstar Inc. of Chicago. The same held true for the longer term as well, with the median manager trailing the index by 0.82% in the three-year period ended Dec. 31, -9.46% to -8.64%.

Representatives of three of the five-largest index managers — Barclays Global Investors of San Francisco, The Vanguard Group Inc. of Malvern, Pa., and Northern Trust — said that they have seen increased interest in index funds in the past 18 months.

Index strategies are best positioned to capture the upside of a market recovery because they are fully invested, said Gerry Mullane, principal and director of institutional sales at Vanguard.

“In the depths of a bear market, at its deepest trough, that’s when active managers adopt their most defensive postures and hold their highest cash allocations,” he said.

Some defined contribution plans have added an all-index tier to participants that offers market exposure without active manager risk, and many participants are choosing an all-passive core lineup with active strategies as smaller, satellite investments to beat indexes, Mr. Mullane said. “[Defined benefit] plans often maintain an index core as a long-term strategy,” he wrote in an e-mail.

DB plans increasingly are moving to more liability-sensitive investing strategies, which increase fixed-income exposure and duration, Mr. Mullane said.

Carter Lyons, managing director in the Americas institutional business at Barclays, similarly said that indexing is attractive because it is transparent and liquid. He said that he thinks that more institutional investors will turn to index funds over the next 12 to 18 months.

Larger players that can offer better analytics and competitive pricing are likely to nudge out smaller index managers, Mr. Lyons said. Barclays is the largest manager of index funds worldwide, claiming $1.44 trillion in indexed assets as of Dec. 31.

Mr. Ivinjack said, however, that he has seen a modest pickup in clients’ using multiple index managers, which could mean increased business for smaller players as well.

Timothy Inklebarger is a reporter for sister publication Pensions & Investments.