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'How LGPS can best use indexes and benchmarks'

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Indexes play a vital role in the modern asset management and investment business.

Not only do they function as objective benchmarks of financial markets’ performance, they are also the basis of passively managed investment product and smart beta, where indexes help manage risk or provide exposure to sources of long-term return.

Indexes were introduced more than a century ago as information tools to gauge stock market sentiment. Now, professionally managed indexes are widely used to provide an objective benchmark of the performance of asset classes, markets and regions.

In their standard form, indexes are capitalisation weighted. Each constituent company is weighted according to the value of its share capital. In practice, index providers adjust market capitalisation figures downward to reflect the proportion of a company’s shares that are freely available for trading – a ‘free float’ adjustment.

In the UK pensions market, the performance of externally managed pension plans used to be assessed via peer group benchmarks, meaning asset managers were measured against each other.

This approach gave asset managers’ clients little protection against unwanted drifts in asset class exposure. It also provided no information on how managers were performing relative to the whole market.

For most institutional investors, peer-group benchmarking has been replaced by the more objective approach of benchmarking via indexes.

Indexes are also vital in the design and implementation of a long-term investment portfolio, including the setting of the investment objectives, the determination of target asset allocation with appropriate buffers and the definition of the investment goals (see the table).

 Using indexes in a defined benefit pension plan
 Step Example  Use of the index
 Set investment objectives  Meet liabilities Set portfolio framework
 Determine asset allocation  Agree equity-fixed income split  Set portfolio framework
 Define ranges  Set buffers for allocation  Set portfolio framework
 Define investment growth  Performance target based on index  Define universe of available securities
 Check whether plan objectives are being met  Analyse performance of portfolio components  Provide basis of performance attribution

Given the central modern-day role of the index as a benchmark in institutional investment management, it must have certain important characteristics.

First, it must comprehensively represent the intended market or market segment. Its construction process must also be transparent and objective.

It must be rebalanced on a regular basis to ensure it keeps up with changes in market composition or structure, and its design must be modular: there should be no unintended gaps or overlaps – for example, between a large-cap and a mid-cap index based on the same equity market.

Passive investment

As an index is a theoretical representation of a market or market segment, it cannot be invested in directly. Nevertheless, in recent decades there has been a surge in interest in investment products such as index funds and exchange-traded funds (ETFs), which aim to reproduce the performance of an index as closely as possible.

The rising popularity of index trackers reflects cost considerations – although index funds do carry fees and incur transaction costs, these are typically small in absolute terms. Rising popularity also shows understanding of the difficulty faced by active managers in consistently outperforming a market benchmark.

For an index to serve as the basis of an investment product, it must have certain attributes. For example, its design features should make it easy for the fund manager to replicate, its constituents should be easy to trade and it should provide a comprehensive representation of the desired market or market segment.

Similarly, smart beta indexes are an evolution of the idea of the index as the underlying performance target for an investment product. However, while capitalisation-weighted benchmarks represent the whole set of market opportunities, smart beta indexes aim to produce specific risk or return outcomes by modifying the index selection or weighting rules.

For example, risk-based indexes use alternative weighting methodologies to produce lower levels of risk or to improve diversification. Factor indexes, another form of smart beta, focus on shared characteristics among stocks, such as size, value, quality, low volatility or momentum. These characteristics, or ‘factors’, tend to produce specific return and risk outcomes, often targeted by long-term investors.

Henry Odogwu, managing director, head of asset owner group, Europe, FTSE Russell

Column sponsored and supplied by FTSE Russell

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