The Pursuit of No Surprises
The reality is that a lot goes into ensuring that things “go right” with index investing. “Making sure a fund tracks closely to the index is a bit like the duck paddling under the water,” Lynn says. “Everything appears calm above the water, but underneath is where all the action is, the thousands of individual decisions that need to be made correctly.”
What goes into some of those decisions? “It’s a combination of things, but it starts with people,” Lynn says. She points to portfolio managers like Emiliano Rabinovich — one of the more than 100 long-tenured indexing professionals at State Street Global Advisors. In this field, experience counts for a lot, she says. “Having been there at the beginning of the indexing revolution, our firm has built up a lot of institutional knowledge about the countless index rules and market nuances required to effectively manage and trade an index portfolio.”
Scale, as it turns out, also matters, according to John Tucker, another indexing veteran and operations expert. At a moment when many firms are trying to offer their clients index strategies, the ability of sophisticated trading and investment processes and proprietary index portfolio management systems to pursue the lowest overall implementation cost can’t be overstated.
“You need professionals who can do a variety of things — everything from implementing an index in the most cost-effective way to creating index change strategies that maintain and build value as companies come in and out of multiple indexes,” John says. “It’s also critical to have local trading folks on the ground who really understand major global markets and can get the best possible price. And you need a rigorous process ensuring that all regulatory and contractual guidelines and market, credit and liquidity risk requirements are met. Honestly, you wouldn’t believe how many people have to be involved at a very detailed level.”
Managing the Unexpected
That brings up an obvious question: What do you do when something unexpected happens or there’s a complex corporate action? For example, when Verizon bought Yahoo’s internet business, the remaining part of Yahoo registered as a closedend fund, which is not eligible for index inclusion, therefore requiring all existing shares to be quickly sold. “That was an exceptional situation that you don’t encounter every day,” says Emiliano, who manages both traditional index funds and a variety of alternative beta strategies. “We had to plan for Yahoo’s exit from the index, and there were a lot of variables to consider.” So, does the index team go to “DEFCON 1” at those moments?
“For us, market events are actually less dramatic than you might imagine,” Emiliano says. “Our portfolio managers and traders meet on a daily basis to plan and discuss things like the timing of trades and how to manage them across different markets. In the case of Yahoo, we started trading a week in advance, liquidating positions over the course of six or seven days. All the while you had to understand things like how every choice you make would affect the hundreds of other companies changing weight, and how you minimise taxes and transaction costs. Do you buy stocks or futures or swaps? How much cash is too much cash in a portfolio? It was a pretty active process.”
Given all the decisions that go into indexing, do clients really want to know about all of the “duck paddling”? “In the past, few did,” Lynn says, though, she quickly adds, that is starting to change. Why is that? “Because,” she says, “investors are beginning to realise that index performance is about a lot more than the expense ratios alone. They want to get educated on it. And when you think about the kinds of things people are trusting us to invest for — retirement, scientific breakthroughs, infrastructure — that’s the way it should be.”