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Index Investing Beyond Perceived Limitations

Investors are starting to see cracks in off-the-shelf beta, and want something more tailored to their needs.

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The lack of vitality in some traditionally relied-upon assets is a growing concern for institutional investors. Forced to challenge themselves and look for innovative answers to meeting their return needs, investors are examining each piece of their specific investment puzzle and considering how it might be customized to achieve their goals. Customization as a trend has merged, in one notable example, with a redefinition of “barbelling,” a strategy familiar to most investors in which portfolio construction focuses roughly half of allocations on short-term tactical investments and the remaining half on longer-term assets.

With the long end of the reconceived barbell pursuing alpha via illiquidity premiums in private markets, the more immediate and tactical end might be considered the beta portion of a barbell strategy – an area where investors have become comfortable with indexing. With the investing landscape as complex as ever, index investments are considered a fairly reliable source of beta that don’t require much effort and tinkering. As is the case with almost everything else in today’s investment environment, however, the status quo is under scrutiny.

“We’re at a very interesting juncture,” says Vincent de Martel, Head of North America Client Solutions, Invesco. “It has been a one-way street of institutions adding more assets to their index allocations. It’s been the default option for a variety of reasons – cost, transparency, a lack of confidence in active management. But we’re starting to see the limits of the model, and some cracks are starting to appear. One is that investors may not be fully aware of the exposures in each index they invest in. Are the exposures consistent with what they want to achieve on a regional and sector level? As index exposures have taken on a bigger role over time, institutions might want to look closer at what they own and why they own it.”



Index customization

The secondary effects of volume in indices have also started to pile up against investors. For example, there are trillions upon trillions of dollars in often overlapping brand-name indexes which are reconstituted each year. The trades necessitated by such a rebalancing might go against the best interests of investors, not to mention the issue of closing prices that may be the result of buying or selling pressure from the indexes. The result can leave investors with an index that does not reflect the true economic value of the securities in it.

Combine what de Martel describes as the limits of indexes with the desire on the part of more and more institutional investors to use their assets to pursue specific outcomes – perhaps a certain kind of macro exposure or achieving an environmental, social and corporate governance (ESG) goal – and you arrive at demand for customized indexes adapted to the needs of each investor. It’s a demand to which de Martel and the Investment Solutions Team at Invesco are responding.

“Our mission is twofold,” says de Martel. “We start by providing analytics so we and the investors can understand what they hold, breaking down an index exposure into regions, sectors, factors, ESG ratings and so on. We have all the necessary tools to facilitate that conversation. The second aspect is to create a custom approach that seeks to achieve investors’ goals. For example, right now in Europe – and increasingly in the U.S. and Asia – a lot of investors have ESG-related goals. More widespread, we’re seeing demand for factor strategies – quality, value, momentum – and how we can blend them into a custom index that allows a custom fixed income portfolio to match certain maturities, for example. We can package investment strategies and goals in an index. We think there will be a shift from first-generation index managers to a newer generation of customized indexes, and we are leading the way.”

Not the same old beta

What investors might find most attractive about adding custom indexes to a modern barbell strategy is that it’s not just an exercise in casting a net for off-the-shelf beta returns. Constructed correctly, a custom index is more the equivalent of an active quantitative strategy with the potential to add returns somewhere between market cap and pure alpha – but without the active quant fees.

“A customized index we create for an investor is more systematic in nature, like factor strategies,” says Neil Blundell, Head of Global Client Solutions, Head of Alternative Solutions, Invesco. “Invesco’s in-house Indexing team is also key to helping deliver tailored index solutions to our clients, in more cost-efficient ways than licensing data from third-party providers. They work with our clients using a systematic, rules-based transparent process that follows an index design and includes the exposures you’re looking for and how you want to achieve the desired outcome. Once we have worked with our clients to create their desired exposures, they can execute on their end, or let Invesco handle the index replication and daily activity. Because indexation is systematic, it can be extremely cost-effective, freeing up client capital to allocate to the other end of the barbell, in private markets.”

As an example, Blundell offers up a hypothetical investor who wants exposure to a specific region’s small caps, combining the size and quality factor. Typically, that investor would find an active manager, which in turn would likely tilt toward smaller caps or mid-caps, and tilt toward towards quality and maybe value. The investor ideally achieves the desired risk and return profile of the mandate, but at a cost which is a hurdle for active managers to overcome from the start. We believe active management maintains an important role in client portfolios for both return-enhancement properties, but also risk-mitigation. We work with clients across the active/passive spectrum, who are using indexed strategies to complement active managers. The benefits of this are twofold: investors can, ideally, offset costs while also reducing tracking error to a benchmark. This is the case for both passive market-beta and factor-based index strategies.

“By leveraging a custom index in that scenario,” says Blundell, “the investor gets consistent and specific exposure to the market exposures and or factors they desire, with the ability to look-back in time and see how the index has evolved. If an active manager is just using static factor weights, that’s probably not worth significant additional cost because that can be replicated pretty easily and systematically.”

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This article was developed in December 2020 by Invesco Solutions, a business unit of Invesco Advisers, Inc. This is for informational purposes only and is not an offer to buy or sell any financial instruments. As with all investment there are associated inherent risks. This should not be considered a recommendation to purchase any investment product. The opinions expressed in this article are those of the Invesco investment professionals, are based on current market conditions and are subject to change without notice.