December 20, 2019

CIOs Bring Passive Investments into the Mix

But will index funds hold on to their appeal if US stocks hit a bear market in the next year or two?

Reported by Joseph Radigan

When Dave Zellner took over in 1997 as chief investment officer for Wespath Benefits and Investments in Glenview, Illinois, passive investment vehicles like index funds were already part of the organization’s strategy.

Over time, he’s added more variety into the mix of passive investments and expanded the purposes he uses them for. By the early 2000s, Zellner added an inflation protection strategy with purchases of US Treasury Inflation-Protected Securities in weightings that matched the Barclays Capital US Government Inflation-Linked Bond Index.

About three years ago, Zellner decided to use index funds to manage Wespath’s holdings in large-cap US stocks by migrating away from the S&P 500 and implementing a passive mandate against the Russell Top 200 Index. The passive investment vehicles are not the only tool in his kit, but they are one strategy implemented on behalf of the roughly 100,000 pension plan participants and 130 institutional clients he serves that are affiliates of the United Methodist Church.

“Our approach is to passively manage in more efficient markets and use active management in less efficient markets,” Zellner said. Wespath employs index funds primarily for US stocks where the market has priced in the information about the issuers, while it uses active strategies for US and foreign stocks, where information is scarce and active management has the potential to add value.

Retail investors have used index funds since the mid-1970s, and they have grown so rapidly that passively managed funds may actually account for more of the market than actively managed funds. But institutions have been relative latecomers to the index fund market. Wespath has a relatively long track record with them, and in the past 10 to 15 years, other institutions have begun to catch up.

“It certainly has become more and more prevalent over time,” said Jon Pliner, head of delegated portfolio management, US, for Willis Towers Watson plc’s benefits advisory business in New York. “I wouldn’t say necessarily that it’s always to replace active management. But often it can be a complement to active management – to help manage overall risk that the asset owners are taking.”

“The reality is most clients do some of both, but which side of that they lean toward is a philosophical issue,” said Jeff Nipp, a senior investment consultant in the San Francisco office of the actuarial and consulting firm Milliman Inc.

In addition to using index funds to complement actively managed funds within an overall portfolio and as a risk management tool, some CIOs for defined benefit retirement plans may employ them based on the plan’s status. A frozen plan with liabilities that are set but no new funds coming in may shift assets into an index fund to better manage its ability to meet payouts to beneficiaries. An actively managed fund may be too volatile and add to the risk that there will be a funding shortfall.

“Whether or not you’re able to withstand the tracking error, or the active management risk, becomes a question that a sponsor has to answer,” Pliner said. “The main thing is it isn’t something that has to be exclusive. There are many places where you can have a blend of active and passive to complement one another.”

Pliner said institutions are using index funds to invest in stocks, investment-grade corporate bonds, and listed real estate investment trusts.

Zellner said Wespath uses enhanced passive strategies, some of which were developed with BlackRock Inc., in which the overall portfolio is built on an industry benchmark, but the weighting is shifted for certain stocks based on a proprietary algorithm to identify long-term investment options.

In October 2018, Wespath had BlackRock develop a low-carbon investment framework for two investment portfolios totaling $750 million. In October 2019, the low-carbon framework was expanded with a $300 million portfolio built upon the Russell Top 200 Index. BlackRock collects data for the customized index based on criteria like a company’s energy usage, consumption of fossil fuels, water management, and waste management. Wespath’s algorithm adjusts the weighting of stocks based on the numbers BlackRock crunches.

Institutional investors also use index funds and derivative instruments based on index funds in ways that are far more complex than those that are familiar to retail investors.

At the W.K. Kellogg Foundation in Battle Creek, Michigan, half of the $8.6 billion portfolio is in Kellogg Co. stock, and the other half is diversified among different asset classes. Joel Wittenberg, the foundation’s CIO, said exchange traded funds (ETFs) that target specific industries and swaps based upon the Standard & Poor’s 500 Index are among the tools he uses for the diversified portfolio. He’s used the S&P 500 swaps to offset some of his excess exposure in the Japanese stock market.

Money managers Kellogg hires in Japan have been outperforming many of its other investments. Instead of letting its portfolio build up an imbalance with too large an exposure to Japanese stocks, Kellogg locked in some gains with the swaps based on the S&P 500 index.

“These managers drive significant amounts of alpha pretty regularly,” Wittenberg said. “But by having these allocations in Japan, it puts us significantly overweight our equity benchmark. What we wanted to do was to preserve those managers and the alpha that they drive, and we can use derivatives to swap that back to the US.”

Kellogg uses industry-specific ETFs when it wants to move quickly into an industry that it feels is undervalued. In 2015, oil futures were peaking, and Wittenberg was concerned they were too pricey. He sold holdings in oil companies to limit his exposure to a decline. When oil futures crashed in early 2016, he saw a buying opportunity and used ETFs to get back into the oil sector before the scheduled quarterly rebalancing of Kellogg’s portfolio with its money managers.

“The ETFs or the index funds give us the ability to be very nimble,” Wittenberg said. “We put on the ETFs to give us that exposure to get us to an overweight position.”

The growth in passive investments has coincided with the longest bull market in US stock market history. As the bull run ages, some institutional managers are repositioning their portfolios to hedge against a downturn. In some cases, that could cause them to pull assets out of index funds and move them over to active managers.

During a bull market, index funds are convenient, low-cost vehicles that let defined benefit plans meet their funding goals. The question for some CIOs is whether index funds will hold on to their appeal if US stocks hit a bear market in the next year or two.

“If the market’s going to go up 15% a year, fine, I’ll just be passive, and I’ll take that, cheap,” Nipp said. “But if it’s going to go up 5% a year, and I’ve got a 7% or 7.5% return assumption, there’s a gap there, and how am I going to fill that gap?”

Can investment officers remain confident about meeting their funding goals with passive investments during a market downturn?

“Maybe you want more active management because then at least you’ve got a chance to not go down as much as the indexes,” Nipp said.

Zellner said that as much as he and other investment officers have to weigh the prospects of a market slump putting a squeeze on returns, how he mixes active and passive investments isn’t influenced by his outlook for the overall market.

“It’s strictly a function of our desire to spend our risk budget in areas of the market where we think we have better opportunities to add value as opposed to markets that are more efficient,” Zellner said.