Asset managers who sell index-tracking funds are hoping "smart" trackers that aim to exploit trends in certain stocks and sectors will help them hold on to their popularity at the expense of stock-picking rivals. Investors have flocked to passive managers, who simply track a market index, after active managers, who charge high fees to beat the market, failed to deliver during the financial crisis.
At the worst point of the crisis in 2008, net sales for European-domiciled index-trackers rose to 48.4 billion euros ($65.74 billion), whilst actively managed equity funds saw net outflows of 159.1 billion euros according to data from Lipper FMI.
As active managers fight back, passive managers are looking to "smart beta" funds to keep attracting investors' money.
These track specially built indexes, rather than a standard market index such as the FTSE 100 or MSCI World, with the aim of delivering higher returns than a standard index would but at a lower cost than actively managed funds.
The bespoke indexes are built using sector- or company-related factors that have been shown to outperform over the long term, unlike traditional indexes which weight their constituents solely by market capitalisation.
"We have seen good demand for index products that are alternatively weighted rather than market cap-weighted," said Hugh Cutler, head of distribution at Legal & General's fund arm LGIM.
LGIM is setting up a range of products using fundamentally weighted indexes developed by investment firm Research Affiliates. These employ criteria such as sales, cash flow, book value and dividends to weight companies.
Research Affiliates data show that these fundamental indexes tend to outperform traditional indexes over the long term. Over 43 years, a fundamental index portfolio outperformed a comparable portfolio of US large-cap equities by approximately 2 percent annually.
An institutional investor would pay about 0.08 to 0.1 percent of the assets invested for a standard passive product, versus 0.35 to 0.5 percent for an actively managed one.
Smart beta products cost more than straight index trackers, at about 0.12 to 0.15 percent, to reflect the skill involved in building the customised index. But they are still cheaper than active funds, making them a tempting proposition for those willing to buy into the prospect of better returns.
"Some of the larger institutional investors are interested because they offer a way of capturing market beta (market return) but with different characteristics to traditional indexes. So as well as reducing costs they offer diversification benefits," said Cutler.
State Street Global Advisors (SSgA), one of the world's biggest passive managers, looks after money for institutional clients in the US and Australia in products that tilt a passive portfolio in favour of value stocks.
These are quality stocks that trade for less than their intrinsic value, but are expected to revert to a value in line with their fundamentals over time.
"Over the long term, value tends to outperform growth. If you can create an index that tilts the portfolio more towards value the investor should earn a premium over the market cap index over time," said Richard Hannam, European head of passive equity at SSgA.
SSgA research found that while the MSCI World Index has returned 6.49 percent per annum between March 1989 and March 2010, applying a value tilt - that is weighting the index towards more value, as opposed to growth, stocks - would have produced an annual return of 8.84 percent.
Hannam said that SSgA was also looking to build passive portfolios that capture small caps' tendency to outperform large caps over time, or which reflect the momentum investing approach. This is based on the idea that buying stocks that have had high returns over the past three to 12 months and selling those that have had poor returns delivers outperformance.
Data from Lipper FMI show that passive investing now accounts for almost 40 percent of all European-domiciled equity funds, up from 16 percent in 2006.
Active managers argue that current market volatility favours stock pickers who can find an edge, but the advent of smart beta funds has added to the pressure on them to justify their fees and deliver returns that beat the market.
"This raises the bar for active managers - if your alpha (added-value) is coming from simple systematic tilts and passive managers can provide this at a lower cost, what are they offering?," said Hannam.
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