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I
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
The number of indices grew rapidly in the late 1990s and early
2000s. Standard & Poor’s (S&P) became a major provider of
indices, and they began tracking how well their offerings did
relative to active managers in the same style boxes as early
as December 2001.
The 10-year S&P Indices Versus Active (SPIVA) scorecard
noted in Chart 40 shows that it was rare for active managers
to outperform their relevant indices. In most instances over
two 5-year periods going back to 2001, active asset managers
underperformed their relevant market index more than 66%
of the time. In only a few instances did active money managers
outperform their benchmark (33%-66% of the time). At no
point did active asset managers outperform their relevant
market index more than 33% of the time.
These results confirm Fama’s and French’s findings. As the
new theory began to take hold in the early 2000s, the first of
two major shifts in investor portfolios took hold. Rather than
looking at their set of active managers holistically to both
capture market performance and achieve beta and potentially
outperform the market and achieve alpha, investors began to
split their approach. For the beta component of their returns,
investors began to look to emerging index and ETF products.
Long-Only Investable Indices and ETFs
Draw Investors’ Beta Allocations
Banks and some traditional assetmanagers sawan opportunity
to take the indices being created in these new style boxes and
make them investable in the early 2000s. This touched off
a wave of product innovation in the long-only world. This
innovation began with index replication funds that offered
investors a pooled fund where they could invest capital and
get exposure to the entire set of companies being used to
generate the relevant index. The fund manager would take
responsibility for rebalancing the funds’ holdings as index
components changed, thus maintaining the investor’s broad
exposure.
ETFs were also created around this time. ETFs hold assets
such as stocks, bonds, or commodities and trade on exchanges
at or near their net asset value (NAV) over the course of the
trading day. In contrast, index replication funds are offered in a
mutual fund construct that only provide for a daily investment
window set at the NAV or closing price for the fund.
As Chart 41 illustrates, growth began with index funds in the
late 1990s and expanded into ETFs in the early 2000s. AUM
in these products have more than doubled every 5 years since
1998. In 1998, total AUM in these funds were $281 billion. In
2003, that total had risen to $606 billion. By the end of 2007,
that figure had risen to $1.46 trillion and at the end of 2010,
index and ETF AUM had topped the $2 trillion mark according
to the Investment Company Institute (ICI).
Chart 5
Index Funds
ETFs
2003
2005
2007
2009
1995
1997
1999
2001
2004
2006
2008
1996
1998
2000
2002
2010
0
.3T
.6T
.9T
1.2T
1.5T
1.8T
2.1T
Trillions of Dollars
Source: ICI
Chart 41: Growth in Passive Index & ETF Funds
“ When I got here, the book looked like a lot of index huggers.
They had a real style box approach,”
– Endowment
“ Last year we made significant changes in the portfolio.
Our previous CIO had been here 20 years. He had all active
managers in the portfolio. I believed there should be a core
of passive investments. We added 25% of our portfolio
to passive in equities and fixed income and liquidated
7 active managers,”
– US Public Pension