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You are leaving SSGA.com
The website you are accessing is created and maintained by another entity. We make no representation or warranty with respect to the information contained on the site or that it is appropriate in all jurisdictions or countries, or for use by all investors or counterparties. The products and services discussed at this site may not be appropriate for sale or use by all investors or counterparties. By providing this link, we are not providing you with investment advice or offering securities for sale to you. All persons and entities that access this site do so on their own initiative and are responsible for compliance with applicable local laws and regulations.
Over the past decade, investor adoption of index-based strategies has soared. To meet the demand, asset managers have formulated new low-cost offerings, driving the competition up and investment management fees down. This dynamic has amplified the emphasis on fees as the key selection criterion for both managers and funds. While fees may be an obvious dimension for evaluation, it offers a limited picture of investor value. Here we will suggest three alternative factors that index investors should consider:
Ask your investment manager to share details on these three elements of their index investing solution:
Why Does Performance of an Index Fund Matter?
Delivering index returns is often thought to be a relatively easy undertaking that any manager can accomplish. However, there are a number of embedded index assumptions that make this task more challenging than meets the eye. Figure 1 describes several notable index assumptions, the realities and potential approaches a manager might undertake to reduce tracking error.
Given these assumptions are known, fund performance will deviate in some way from its respective index. For this reason, it’s pragmatic for a manager to assign expected tolerance bands as a form of performance measurement. This is a critical step in the portfolio construction process, as it helps establish performance expectations. If the performance differential between the fund and its respective index substantially deviates from its tolerance bands over time, the investor may be incurring an additional cost (i.e., negative tracking error) or potentially taking on unintended risk in the case of significant outperformance. That said, it’s critical that an index manager finds the right balance of minimizing tracking error and risk when overcoming these variables.
Why Is Size Important?
Size supports scalability and provides breadth and depth from a product perspective. A substantial index asset base may serve as an indicator of an asset manager’s commitment to the index style, helping to pave the way for innovations in process improvements, technology, new product development or enhancements to existing strategies.
Large index managers are also able to support the G in ESG (environmental, social and governance) investing through asset stewardship, using proxy voting to influence corporate actions.
Furthermore, size may potentially help a manager better track a respective index, particularly if the index is broad and has a large number of constituents. For example, the popular MSCI ACWI ex US IMI Index, which covers developed ex US and emerging markets, has more than 6,000 constituents presenting challenges from a replication standpoint in a small fund. So ideally a larger asset base may be able to more easily replicate the index, as it can hold more stocks in the index. In addition, sizable funds with a diverse client base can often accommodate larger contributions or redemptions. This can potentially lead to less turnover, assuming the manager invests in futures or utilizes an internal crossing network, whereby contra investors’ flows can be netted against one another.
And finally, size can translate into more effective implementation. This is particularly meaningful in the DC arena, which encompasses millions of investors and countless transactions. In this context, a large fund manager may be able to more easily absorb money movement with less impact to fund performance. In practice, this means a large fund can potentially accept substantial cash contributions without having to immediately buy securities to house the assets. Instead, managers can buy or sell futures to reduce transactions costs. More importantly, a manager with a large and diverse client base will likely have more contra flows that can be netted against one another, assuming the manager has established a robust internal crossing mechanism. This process can provide substantial savings to plans and participants, often in excess of the management fee of a fund.
What Is the Most Appropriate Vehicle for an Index Fund and Why Does It Matter?
Index funds are offered to US-based institutional investors in several structures, including mutual funds, pooled trusts like collective investment trusts (CITs), exchange-traded funds and separately managed accounts. Depending on factors such as the investor’s tax status or legal structure, investment time horizon, liquidity and need for customization, one vehicle may be more suitable than another for certain investors. For the purposes of this section, we’ll focus on the differences between mutual funds and CITs, which are pooled funds regulated by the US Office of the Comptroller of the Currency and often the most suitable index vehicle for large-scale, tax-exempt entities such as defined contribution plans.
Despite almost 50% of defined contribution plans in the US offering CITs on their plan line up, mutual funds remain the primary default index fund vehicle option. Some reasons may include the perception of “portability,” participant familiarity and ability to access publicly available information. However, CITs offer a number of advantages over a mutual fund. Some of those advantages include:
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Note: Availability of internal crossing at State Street Global Advisors may be affected by your asset class, vehicle type, jurisdiction or other factors.
It’s worth noting that not all CITs are the same, and can vary by manager. For that reason, investors should discuss with their managers:
Beyond Fees
Given the attention paid to fees over the past few years, selecting an index manager has become somewhat of a “passive” process. Today, fees have settled to record lows and investors are now looking for alternative ways to evaluate index funds. Performance, size and scale, and the index vehicle are meaningful dimensions to incorporate into the due diligence process and will most likely offer a new and fresh perspective on the index marketplace. Choosing the right index manager matters — and asking better questions will help separate the rigorous from the regular.