First came “active” management: A pension fund, endowment or foundation hired managers that it felt could get results that “outperformed” the market.
That, though, had its comeuppance in 2007 and 2008. “A lot of asset managers got disillusioned with active management,’’ after their investments went south in the wake of the credit crisis and the active seekers of alpha “didn’t provide protection” from the downdraft. Then came “passive” management: The idea that your investing organization was spinning its wheels and overpaying for the privilege of trying (and failing) to get an above-market return. That the best tack was to just follow the market or a piece of it and cut the costs of executing that “passive” approach.
Exchange-traded funds, based on benchmarks that track baskets of stocks, “made passive investing so much easier,” said Tom Goodwin, senior research director for Russell Indexes. But passive investing hasn’t generated the kinds of returns that pensions and other funds have needed to meet their objectives or responsibilities. So the index supplier has swung back with the tide, to a degree, to create benchmarks that track “quasi-active” strategies.
This year, for instance, Russell has come up with a variety of Geographic Exposure Indexes. These indexes give “exposure” to emerging markets around the world, but only invest in companies that are based in the developed world. Those companies get ranked by the percentage of their revenues that come from emerging markets, the overall amount of their revenues from those markets and the capitalization of the company, overall. The companies are drawn from industrialized countries on the North American, European and Asian continents, primarily.
Roughly 125 out of the 400 companies in the global large capitalization index come from the United States, for instance. Each index follows stated rules and the components are reset once a year. By dictate of the rules of the index. Not a human stock selector. “There’s no human judgment. It’s all rules-based and mechanical,’’ said Goodwin. “We don’t tinker with it.”
There are no investment committees, for instance, with Russell’s rules-based indexes. The only time a human steps in is when some event, like a unique or irregular corporate action of some sort, creates an exception that must be interpreted. This is for pension funds and other institutional investors who want to get a taste of active management without swallowing the fees charged by active managers. Because, in effect, a slow speed version of algorithmic trading is taking place: Rebalancing creates buy and sell orders that can be carried out, in an automatic fashion.
Once a year.
There are, for instance, a variety of indexes that Russell provides that pursue what Goodwin calls GARP strategies: Growth stocks available at reasonable prices. The flavors differ, but in each case the approach that is being mimicked is laid down in strictures that can be followed, mathematically, as the values of the stocks change.
Other strategy indexes put different weights on fundamental financial results that components in the benchmark are achieving. These can be core elements of income statements and balance sheets, such as revenue achieved, operating margins, dividends paid, earnings retained or other such accounting measures.
This is different from the typical weighting approach used by a broad, passive index, such as the Russell 3000. In that flagship index, Russell tracks the 3,000 largest U.S. companies, representing 98% of the stock market. But they are not ranked by revenue size, like the Fortune 500. They are not ranked by net income, as a stock screener might. They are ranked by market capitalization, which represents the overall value put on the company’s shares by all shareholders, who bid up or bid down that value based on their judgments of the firm’s overall prospects.
Its Top 10 holdings, for instance, include the obvious: Apple, Exxon Mobil, General Electric, IBM.
This can have the benefit of being as passive as is humanly possible, taking out the “human-decision making that is really great when it is right and really bad when it’s wrong,’’ said Goodwin. But the firm, like other index shops, has added a wide range of other passive indexes that aren’t quite so passive. They have “styles” of indexing that follow “styles of investing, such as “value” stock investing or “growth” stock investing. With the advent of rules-based strategies, as well as style indexes, an index provider can give producers of exchange-traded funds means of giving a large investor a much wider spectrum of means to approach markets and try to get above-average returns, while keeping costs down.
“It’s no longer a binary choice of active versus passive,’’ said Goodwin. “It’s now a continuum of choices you can combine,’’ to achieve an improved result. An index can only provide, though, a “quasi-active’’ result. If truly active management is sought with a single star manager or a group of professional managers, then the pension fund, endowment or foundation has to look elsewhere. Of course, that doesn’t necessarily mean looking outside Russell’s walls.
The index group can, Goodwin notes, can point a customer with which it has been consulting to a rather sizable asset manager in its own right: The investment management and research division of Russell Investments. That unit handled $152 billion in assets as of June 30.
