Bowling Over an Index Fund
December 6, 2010
An index fund, by design, is intended to simply replicate the movement of stocks in a particular financial index, such as the S&P 500.
And if asset managers (or their investing clients) are to believe Vanguard Group founder John Bogle (Money Management Executive, November 29, 2010) or the last instructions of dying banker Gordon Murray ("Your Money," New York Times, November 26, 2010) it's futile to try to actively manage money, for a better-than-market return.
Yet, as the "Super Bowl of Indexing" debuts today in Phoenix, make no mistake: This is how professional asset managers make their own money: By adding value to their clients' investment prospects-and results.
Enter the idea of "enhanced indexing." This is a concept, as defined by SS&C Technologies of Windsor, Conn., of adding value by creating portfolios that mirror indices-and then striving to outperform the index being mirrored, with them.
SS&C does this by providing portfolio managers with a series of tools and techniques within an order and execution management system it calls Antares.
The goal for the manager of a given mutual fund or exchange-traded fund: use the techniques to increase returns, beyond the benchmark index. Aim for 30 basis points more or 100 basis points more and manage to that.
In effect, give managers a bat with a larger sweet spot than that held by the next outfit. And then letting them swing as hard as they want.
"We're giving them an aluminum bat that hopefully won't crack either," said Chuck Giessen, senior vice president of the company's financial markets group. The group counts as one of its batters a fund complex with $74 billion under management.
The system allows a manager to create multiple "layers" or views of a given portfolio. Then those models can be tested against different models that attempt to reduce risk and increase returns, using different tacks.
The four models carry the stiff titles of Flexible Enhanced Passive Management, Cash Management Based Products, Low Tracking Error Quantitatives and Low Tracking Error Fundamentals. But, boiled down, they amount to managing by exceptions, by return on cash, by selectively picking securities that are outperforming the benchmark and selectively picking securities that are backed by strong fundamental research (see chart).
If, for instance, you think you can pick opportunities based on changing market conditions, you can see the effects, using the Flexible Enhanced Passive Management model. Is the basic portfolio underweighted in oil stocks? Ripple through the effect of overweighting it. Think you also have a grasp on a couple likely mergers? See what the effect is on the portfolio of adding those targets. Know a couple others that normally move in parallel, but that you think you see diverging? Ripple some assumptions on trading in that pair through the model.
In effect, the program lets you see the results of "tilting" the index fund.
"The portfolio manager can have an indexed or index-related strategy or it can be an optimized-index [strategy] or it can be index-tilted for dividends or index-tilted for reducing currency exposure," Giessen said.
Or just about any realignment that can be sliced and diced. Antares "looks at securities from a settlement date position and then it can fragment and atomize" the portfolio as need be, he said.
It can calculate the profit and loss in a portfolio on the fly. And it doesn't need to focus just on settled positions. The system will calculate returns on an unsettled basis or even positions as orders are entered.
The atomizing can take the process down to calculations that figure the effect on an individual client, or month-to-month results, or taxable returns, or yields, or cash flows, or other metrics.
Naturally the system figures out the trades, along the way. Say you want to reduce your total positions in a set of stocks and bonds by 10% and spread it across half your customer base; the system will tell you how to get the pieces executed, where to send the equity orders and where to send the bond orders.
SS&C can't quantify if the modeling does, in fact, enhance returns beyond straight indexing. But that is not the software's responsibility, in Giessen's view.
"It may well be that the software developers and project managers will tell you that they get portfolio outperformance because the software is so good," he said. "But that seems like a really good way to tick off your clients."
That's because, he says, the extra 30 or 100 basis points is not due to the software. "Portfolio performance is as good as the portfolio manager; trader performance is as good as the trader's value add," he said. "What we provide them with is technology that tries to eliminate negatives and gives them more tools to be smarter traders or smarter portfolio managers."
Enhancing An Index