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FOR PROFESSIONAL INVESTORS ONLY
Blending Insights
Current European industry
perspectives on blending active
and index products
October 2012
Table of conTenTs
Introduction ...............................................................................2
Executive summary ....................................................................4
Current industry practice ...........................................................7
Catalysts ..................................................................................11
Trends in indexing and blending ...............................................15
Methods for blending ...............................................................19
Challenges and obstacles to blending ......................................23
Lessons on indexing and blending ............................................27
Looking to the future ................................................................29
Conclusion ...............................................................................33
Blending Insights: Table of contents
1
2
Introduction
Blending Insights: Introduction
The low yield world is focusing investors on the costs of
investing, while changing regulation is leading to greater
alignment between clients’ investment portfolio
choices and their risk-return profiles. Together these
factors are transforming the use of active management,
indexing and the blending of investment styles across
the asset management industry.
We are consistently asked by clients how other
professionals are approaching the question of whether
and how to blend active management and indexing.
Often we find that this discussion remains mired in an
active versus passive debate.
As a result, we set out to better understand the
current thinking of individuals and institutions. To do
this, we interviewed 35 advisory, discretionary and
multi-asset institutional businesses based in 8 EMEA
countries, namely Netherlands, Switzerland, UK,
France, Denmark, Germany, Israel and Italy. We met
with wealth and private bank advisory fund selectors,
discretionary and multi-asset institutional portfolio
managers, and research and ratings houses.
The participants interviewed oversee approximately
€2.4trn assets in the active fund, indexing or blending
space for corporates, insurance companies, charities,
high net worth individuals and retail clients
1
, including:
``
Five of the top 10 global private banks by
Assets Under Management (AUM)
2
``
Private banks with estimated AUM of €1.2trn
in Europe
3
``
Multi-Asset institutional funds with approximately
€142bn of AUM
4
Our respondents embody a broad selection of the
European asset management industry: the range of
participants included those with predominantly active,
blended or passive investment processes.
To gain insights into how they approach blending
we asked:
``
How far have they moved down the path of blending,
if at all? What has influenced them along the way?
``
Where are they using active management, indexing
or both? What methods are they employing?
``
What has catalysed them? For those that haven’t
begun blending, why not?
``
What challenges and obstacles in blending are
they facing?
``
What advice on this topic would they give others?
``
And finally, what is their view of the future?
Some of our participants’ insights into the dynamics of
blending were unexpected; especially the impact that
values and philosophy have on blending investment
processes. These insights, in our view, are helpful to
firms in reviewing their management of assets from an
investment and business perspective. Specifically,
they may assist in process appraisals against
alternative approaches, drawing attention to key
factors to consider and ultimately determining the
right goals for organisations.
It is a time of rapid change in the European investment landscape. A challenging
post-financial crisis environment is driving the need for greater diversification to
seek returns and manage risk. Investors are diversifying across a wider range of
asset classes, making more use of tactical strategies and demanding more
flexibility in the products they use.
Introduction
1 Source: BlackRock, end 2011.
2 Source: Scorpio Partnership Private Banking Benchmark 2012.
3 Source: Interim financial statements of respective private banks, June 2012 and estimates from BlackRock.
4 Source: BlackRock, end 2011.
3
Introduction
Blending Insights: Introduction
278
-814
246
282
-246
253
197
265 258
280
322
143
-1,000
-800
-600
-400
-200
0
200
400
EURO BILLIONS
Active equity and fixed income Index equity and fixed income
2007 2008 2009 2010 2011 1H 2012
82%
84%
86%
88%
90%
92%
94%
96%
98%
100%
2004 2005 2006 2007 2008 2009 2010 2011 2012
% of AUM in ETFs% of AUM in index funds% of AUM in active funds
The growth of indexing and blending
The need to consider all aspects of active-indexing investment is very evident when the market share growth of
indexing in AUM in Europe is considered.
Over the past five years, indexing has seen a steady inflow of new assets while the active management industry
has experienced one of its most difficult periods. Since the onset of the financial crisis in 2007, cumulative net
new flows into equity and fixed income indexing funds have totalled nearly €1.5trn, while active equity and active
fixed income fund net new flows have been effectively zero, driven by significant outflows in 2008 and 2011.
Indexing, through index mutual funds or Exchange Traded Funds (ETFs), now accounts for over 11% of AUM in the
European asset management industry. This represents a doubling over the last six years. The growth of indexing
has contributed to the increased combination of active management and indexing within blended strategies.
5
Global institutional and retail net flows
aUM split of active and passive european funds
5
Source: Global institutional and global retail NNB: eVestment Alliance.
5 Source: Simfund, BlackRock. Please note: This data is for European domiciled funds, which excludes AUM in Cayman Islands,
British Virgin Islands and Bermuda domiciled funds.
Blending Insights: Executive summary4
“There’s no black and white answer. That is probably the biggest lesson we’ve learnt.”*
The issue of how to approach blending is often seen as the search for the optimal
balance of instruments that will yield one definitive answer to be applied to all portfolios.
The reality is very different; as one participant put it, it’s “art more than science”.
What makes this the case? It is not just the lack of a single solution to blending but
also the broader factors and influences that impact investors’ overall approaches.
Investment philosophy is key:
whether a
participant focuses primarily on asset allocation and/or
fund selection, their conviction in active or passive
management and the characteristics of their client-base all
help define their overall thinking. Typically, these are the
starting points for how and whether a respondent engages
in blending and indexing more so than any analysis of what
market may or may not be efficient.
There is no single answer to blending:
we find
our participants’ blending methodologies to be a mixture of
quantitative analysis and qualitative judgment or, in some
cases, a perception of what’s best. With no single agreed
method, the most oft-cited consideration is an assessment
of asset class efficiency. While the majority make this their
starting point, others challenge it, focusing on what is
available for that exposure at any given time. The need
for a dynamic blending process is required given the
market cycle, varying investment time horizons and
changing correlations.
Shifting to a blending strategy is not easy:

For European advisory businesses, one obstacle is the
current rebate-based revenue model. In the multi-asset
institutional and discretionary space, those coming from
an active management background can find taking full
advantage of indexing a challenge. The existence of an
in-house asset manager can create tension within an
organisation when switching funds; yet can be of benefit
given the additional transparency they offer relative to
external funds. Stakeholder management is essential.
Across all businesses, respondents found that adopting
indexing and blending requires them to re-think their
value proposition and how they communicate their product
line-up to their clients.
What is driving this change?
One of the main
catalysts is a combination of rising client awareness of
indexing, and growing sensitivity to costs in a post-financial
crisis world of lower yields and lower expected returns. The
increasing importance of asset allocation, including more
tactical investing and a tougher environment for active
management, has also led many respondents to use
indexing and blending for the first time. Concentrated in
certain countries, namely UK and the Netherlands,
regulations are driving firms to re-think entire business
models. While most of the focus is on the impact of no more
rebates on the advisory revenue model, regulators are also
forcing businesses to take greater consideration of client
suitability, appropriateness of advice given clients’ risk-
return profiles and the balance of financial products in
discretionary portfolios.
Blending often evolves:
what is surprising is how
many of those that do blend found their investment
approaches evolved from experiences rather than a strategic
decision. This is often reflected in the way they have begun
to use blending and indexing: evolving gradually from cash
flow management and tactical use to full blending across
strategic portfolios. Once businesses start to utilise indexing
or blending, a key consideration is how firms fit these new
solutions into their existing product line-ups and
communicate what their new value proposition is.
* Please note: The citations used throughout the document are direct quotes from our respondents.
Executive summary
Executive summary
5
From these experiences, what advice did
our respondents have?
Blending is a learning
curve: active management and indexing products require
different operational and implementation knowledge to be
developed. Don’t shy away from adapting the product
offering due to the fear that clients won’t accept it but
remember communication and a focus on costs are key.
Key findings:
three identities emerge
Actively Active
(30% of participants)
These participants are currently focused on using active
management to generate alpha. Indexing, where it is
used, is only for cash flow management or as a last choice
if other (stock selection or active fund) alternatives are
unavailable. A high level of conviction in active management
and focus on active fund or stock selection is a key
consideration for these managers.
Within the discretionary management space 40 per cent of
our participants are actively active. A minority of these are
under increasing external pressure to start blending but yet
to start. Others, including a small minority of our multi-
asset institutional fund respondents, are comfortable with
their primarily active fund/stock-selection approach and
have no intention of adopting indexing or blending in any
meaningful way.
Among the advisory firms two thirds of those we spoke to
are actively active; their current revenue model being one
obstacle to adoption of indexing on their platforms.
Embracing Blending
(25% of participants)
For those engaging in blending, their development varies.
Approximately one-third of discretionary managers and
20 per cent of multi-asset institutional managers are here:
either adopting indexing for tactical or short-term
exposures, or moving towards a more comprehensive
approach to blending. Catalysts such as client-demand,
the market environment and active management’s relative
performance are balanced for some against a historical
position as active-only managers and fund selectors.
Dealing with the internal and external obstacles to
blending is therefore a key focus. While initial catalysts for
doing so have typically been external, many find internal
momentum grows where they see the impact on business
and client reception to be positive.
The rest of our advisory participants are typically
embracing blending and indexing on their platforms by
moving to a fee-based business, especially for new clients.
In fact, the introduction of more model-based advisory as
part of the new fee structures is blurring the line in terms
of value proposition between advisory and discretionary.
Agnostic Allocators
(45% of participants)
Finally, we find respondents with a more agnostic process
for blending and the use of indexing. A primary focus for
them is to deliver alpha through asset allocation with the
vehicle for implementation often a secondary consideration.
25 per cent of our discretionary and 75 per cent of our
multi-asset institutional respondents were typically
“agnostic”. Some respondents are now finessing their
blending processes to see how far they can go with all the
tools at their disposal. Others have focused on building
index-only products, either as an end-game or a step
towards a blended offering.
Regarding the future
Our participants gave us enlightening views on where the
industry may be headed:
1. The expectation of fee and margin compression across
the industry is strong.
2. There is a high level of consensus across all identities
that there will be a shift away from the “middle ground”
of active management towards indexing for beta on one
hand and higher active alpha on the other. The “middle
ground” is defined by many of our participants as active
managers centred on close-to-benchmark portfolios.
3. Other participants question what indexing will mean in the
future as this investment process continues to evolve.
4. In advisory, the post-retrocession world, while creating
a more level playing field for indexing and active
management, could herald a barbell shift by end investors
towards discretionary and execution-only services.
Where does blending go?
Most respondents share the view that blending and
indexing will continue to grow as participants develop their
methodologies and product offerings. But is this trend
inexorable or will there be a tipping point? A point, some
believe, where the greater adoption of indexing creates
more opportunities for alpha and a reversal towards active
management. We shall see.
Blending Insights: Executive summary
Actively Active
Embracing Blending
Agnostic Allocators
Actively Active
Embracing Blending
Agnostic Allocators
Actively Active
Embracing Blending
Agnostic Allocators
Actively Active
Embracing Blending
Agnostic Allocators
Actively Active
Embracing Blending
Agnostic Allocators
Actively Active
Embracing Blending
Agnostic Allocators
Executive summary
6 Blending Insights: Executive summary
Executive summary
7
Current industry practice
Blending Insights: Current industry practice
Current industry
practice
Blending Insights: Current industry practice8
We start by examining the broader factors that influence the way our respondents
approach the use of indexing and blending.
Investment philosophies
“I’ve been a fund selector for so many years, and I have
to believe that I can add value through selecting funds.”
Fundamental conviction in
active management
Many of our respondents have come from a background of
active management, whether as fund selectors, active
managers or Independent Financial Advisors (IFAs). Their
historical position is one of “active works” and a primary
focus on stock or fund selection.
Amongst the respondents who are
actively active,
there are those who are focused on adding value through
fund selection and feel under no pressure to embrace
index products. In their words, they have “been able to
demonstrate that by going through a thoughtful and
considered process, we can identify managers we believe
will deliver their objectives and therefore produce a bigger
return than you can get from just getting market exposure”.
Some with active-only discretionary products highlighted
that while their firm historically has had a high conviction
in active management, the simple reason for not utilising
indexing or blending is that the business is not ready yet.
For others the journey is just starting:
“Up till now we’ve been of the school that says alpha
exists, but we’ve now come to a point that we agree it
could be useful to use index products.”
This manager is considering using indexing for core beta
where previously they have been comfortable using “middle
ground” active managers.
Finally, we find investors coming from a position of
historical conviction in and use of active management
and now embracing blending. Understandably,
the shift to blend and introduce indexing has been a
challenge given their starting points. A large discretionary
manager reflects:
“We were quite anxious at the beginning.
What does it do to your earnings model?
And how will clients respond?”
For those who have “done the difficult part” of training
themselves on indexing products and risks, the question
they now face is “what can we actually do with these tools”?
Agnostic to active management or indexing
At the other end of the scale we found respondents who
hold an agnostic view towards active management and
indexing, our
agnostic allocators. This is most
prevalent in the multi-asset institutional segment. As one
multi-asset institutional manager explained:
“So, we really try to go from an agnostic standpoint,
throw it all in the machine and purely from a
quantitative perspective, as emotion free as
physically possible, to say ‘is it possible for a fund
selector to find value?’”
Whether a portfolio is positioned through active
management or indexing is driven by the investment case,
rather than a commitment to a particular implementation
style. This is a view that has grown in recent years as
asset allocation has increased in importance for many
professional investors. As a result, for them active
management or indexing has become just a vehicle to
deliver the right exposure:
“We’ve always said the primary point for us is getting
asset allocation all right. How you implement that
asset allocation pool is a secondary decision.”
Current industry practice
Current industry practice
9
One institutional manager felt that to implement a multi-
asset investment process, it was important to “look at all
the tools that you have available and assess whether those
tools make sense, rather than just say: ‘active management
is this, passive management is this’”.
Resources play some part in these decisions. A number of
institutions told us they have developed their business
around asset allocation due to the lack of resources they can
dedicate to fund or stock selection. As this lack of resources
is addressed, the next step in their evolution could result in a
greater use of active management vehicles in the future.
Additional investment criteria
What other elements of investment philosophy determine
active or indexing usage?
A manager weighted towards active management explained
that the key driver of their investment philosophy was
sustainability (or socially responsible investing). The use of
active funds or their own stock selection was driven by the
fact that most of the indices that indexing products track
don’t qualify as sustainable.
Another multi-asset institutional manager emphasises
transparency or predictability in their choice of investment
process. This has led them to adopt a high weighting of
indexing instruments in their portfolios not because of any
“bias against active management” but because they see
“a cost of active, because it makes things less transparent
for us, as an asset allocation-driven style strategy”.
The need for focused delivery
to their clients
“So, the reason for doing it was to meet the client’s
needs. They (the clients) said ‘we want to deliver
performance in a certain volatility range, whilst
keeping the price down’. We thought the most efficient
way of doing that was to have a core of passives.”
The third key driver of how professionals approach blending
is their client base. The key point is that the demands of the
specific client, for example for low-cost solutions or certain
benchmarks within an asset class can, and will, over-ride
the firm or team’s conviction concerning implementation.
From an institution’s standpoint, whether it is advisory,
discretionary or institutional multi-asset, do they sell asset
allocation, stock or fund selection, or a combination?
For example, when discussing the challenges to greater
use of indexing in the advisory industry, one of the largest
advisory businesses in Europe noted the importance of
“what you hang your value proposition on in terms of what
you’re charging your client for”. In their view, a client who
values asset allocation makes it easier for the advisory
business to become agnostic between active management
and indexing exposure. However, if the end client valued
research or fund picking, then “picking an ETF actually
detracts from the value proposition that the client values”.
Across advisory, discretionary and institutional multi-
asset, there are varying levels of client engagement in
the management of portfolios.
Multi-asset institutional/discretionary
In the multi-asset and discretionary businesses, we
identified a difference between institutional end-clients
and retail/wealth clients.
Retail/wealth clients: Many discretionary managers
highlighted that the main focus of their retail/wealth
end-investors was on performance and cost. According
to one manager “as long as that performance is ahead
of benchmark, then the client doesn’t much care” what
building blocks are used to deliver it.
Institutional clients: For institutional clients, however, the
clients are more discerning about the constituents of their
portfolios. In the words of one multi-asset institutional
manager, “they’re much more prescriptive about the types of
instruments you can use”. In fact, another multi-asset
manager felt that having a comprehensive methodology for
blending was a competitive advantage in the institutional
space. As regards pension fund mandates, a manager
explained the impact of changing regulation on how their
clients interact with them:
“Of course, the regulator tells you that you are in
charge of their portfolio. Even if you choose a
fiduciary, you are still in charge and you don’t just
say, ‘great, tell me in ten years what happens’.”
A key factor in whether the institutional end-investor drives
a manager to implement investment views via active
management or indexing vehicles is cost. One institutional
manager claimed that in their experience, large institutions
with pricing power have been a driving factor towards their
greater use of indexing.
Advisory
On the advisory side, the dynamic is very different with the
ultimate decision for an investment and its implementation
sitting with the end client. As a result, having a full offering
across the active management-indexing landscape is
increasingly important. In the view of one advisory manager,
“regardless of your own opinions, you need to be able to cover
all the bases anyway”. As such, irrespective of what they may
want to recommend, he felt that his private bankers will be
ultimately guided by the views of their clients.
Blending Insights: Current industry practice
Current industry practice
Blending Insights: Current industry practice10
Other client characteristics
Interestingly, respondents also highlighted the impact that
age and domicile can have on their use of blending and
indexing. Several highlighted the preference of their
older investors for individual stocks and bonds whereas,
according to one participant, “my personal feeling is
that the younger investors are much more in favour of
investing in ETFs”.
One global advisory manager highlighted differences driven
by the location of their end-investors. According to them,
the US and Asia lead the way in the adoption of indexing
due to being more transactional markets whereas
European investors are more driven by long-term
considerations. As a result it was important for their
business to adapt their offering for each jurisdiction.
In advisory, what is your
business structure?
Finally, in the advisory space the structure of the business
is a very important determinant of how active management,
indexing and blending are actually implemented. While
some firms have a centralised process, this is not always
the case.
One advisory head explained how in their firm, “the advisor
is king’”. As a result, the fund selection process “breaks
down” as the advisors don’t need to follow the fund buy list
when constructing client portfolios.
It is unclear how this structural influence will evolve as
much of the industry moves to fee-based models.
Current industry practice
``
The level of conviction towards active management is a key driver of whether or not to blend.
An agnostic starting point typically implies a greater use of blending and indexing.
``
Criteria such as socially responsible investing or transparency often drive investment style.
``

Client demands can govern implementation, especially for businesses with institutional clients.
``

In the advisory business, the level of centralisation in a business is an important determinant
of blending and index usage. A full offering across the active management-indexing
landscape is increasingly important.
Current industry practice
11
Blending Insights: Catalysts
Catalysts
Catalysts
Blending Insights: Catalysts12
What is driving professionals to change their investment approaches? Through the course
of our conversations, we identified several catalysts, most notably the impact of client
demand, cost constraints within the current challenging investment environment and
changing regulation.
Client-driven
Unsurprisingly, client demand was highlighted by all our
respondents as a major catalyst.
Multi-asset institutional/discretionary
Many discretionary managers are finding that to meet their
clients’ needs, they have to “deliver performance in a
certain volatility range, whilst keeping the price down”. As a
result some felt that now “the most efficient way of doing
that was to have a core of passives, depending on their level
of risk tolerance”.
Clients are now challenging managers choice of vehicles
more and more: they have “seen certain markets where they
believed they would have a good performance and then the
active manager got it wrong. So they don’t want that risk
anymore”. Their reaction is to say: “Just give me the
benchmark and at least I know what I’m going to get.”
Questioning by clients is playing a key role in pushing some
of the more reticent
actively active businesses to the
point where they acknowledge the usefulness of index
products. Their clients’ expectations are such that index
products are expected to play a role in their portfolios. One
such participant commented: “There is some expectation in
investor communities, in the market, that passive products
should play a role in people’s portfolios.” They noted the
importance of the media in making “clients more aware of
relative performance to a benchmark now, than they were
five years ago”.
Advisory
In advisory, clients want greater flexibility and place a
higher premium on liquidity. For example, one business
commented: “The inclusion of ETFs into the recommended
list started about one and a half years ago due to client
demand, as ETFs offer the most cost efficient way of
managing some asset classes, especially if these asset
classes are overweight tactically within their portfolio.”
A large private wealth business highlighted the impact of
client awareness by stating that since their clients were
now aware of the existence of index products, it was
necessary to embrace them “rather than just treat them
as the scary alternative to retail funds”.
Regulation
As expected, regulation was identified as a major driver.
While this is widely acknowledged in the advisory business
with the UK Retail Distribution Review (RDR), regulation
is also impacting blending and index usage in the
discretionary business. The main countries where this is
occurring are the UK and Netherlands but the extent to
which the regulator is perceived as influencing the choice
of different products across different regions varies.
In particular, the Dutch regulator, the Authority for the
Financial Markets (AFM), is seen as encouraging particular
types of products, while the UK regulator, Financial
Services Authority’s (FSA) guidance is more focused on
the suitability of funds for end investors.
In the Netherlands, a Dutch discretionary respondent
described how the AFM has seemed to take a
pro-indexing approach:
”The regulator has played a very interesting role here.
A few years ago they were more or less telling
everybody you should offer passive over active and I
remember the asset managers at that time were
quite astounded that the regulator was taking such a
pro-passive approach.”
This pressure from regulation is felt across different types
of investors, highlighted by a large Dutch pension fund
manager drawing attention to the fact that the trustees of
pension funds are finding indexing exposure easier to
justify on a risk-return basis than active fund exposure.
According to the manager: “The regulation is not outrightly
saying, ‘You have to go passive’ but, of course, the trustees
have to justify what they are doing and it’s easier for them to
Catalysts
Catalysts
13
justify a passive selection than an active selection, which is
inherently more risky in their mind.”
Unlike the AFM, the UK’s FSA is not perceived as directly
steering the investing community towards one type of
investing. Instead, UK regulation is described by a number
of clients as being very focused on two issues:
``
the suitability of investments for the end investor; and
``
the investment process rather than investment
performance.
A market participant claimed that “the regulators are not
worried so much if it works, but more about if it’s suitable for
that particular risk profile”.
Linked to suitability of product for clients is the issue of
transparency. One of the consequences of more regulation
is that transparency is seen as a key differentiator of
financial services companies. It is perceived that index
investing provides an attractive level of transparency.
Across regions, regulators are encouraging greater
emphasis by market participants on justifying investment
decisions and tailoring products to clients’ risk tolerance
levels. Discretionary and advisory businesses are
encouraged to screen clients to determine their risk profile
and match investments to those profiles. The regulators
are seeking to ensure that a range of different solutions are
on offer, increasing the likelihood that investors are advised
to invest in appropriate solutions. In the opinion of one
market participant, the regulator is “trying to make sure
that solutions are not too simplistic. Solutions could be an
income producing solution, a growth solution, a capital
preservation solution or a drawdown solution”.
The increased transparency that changing regulations are
generating is “a trend that anyone who leans against will be
hurt” according to one discretionary manager. In his view,
anyone who embraces that trend will have a competitive
advantage and that “clearly passive solutions are in a much
better place than active solutions to provide that level of
transparency”. In the words of another, as an industry:
“We need to rebuild trust. And there passive helps,
because it’s transparent.”
Impact of current
investment markets
“The starting position on returns on equity and fixed
income does not do the trick anymore, so you have to
do more, you have to be more diligent.”
Over the last few years the breakdown in historical asset
class correlations and the increased volatility of capital
markets has increased the need for effective asset
allocation and provided more opportunities for tactical
strategies to add value. In addition, low yields and returns
in markets have ensured that it is no longer possible to
just invest in a combination of core equity and bond
investments, and expect to deliver a targeted return.
These changes in investment markets have been a catalyst
to stimulating a greater focus on indexing and the need to
blend within investment processes.
In summary, a number of current market factors such as:
``
the era of low yields and low returns;
``
the greater need and opportunities for tactical strategies;
``
the requirement to protect active fund exposure;
``
the use of index products in enhancing cash
management; and
``
the need for greater liquidity
have led to the increased blending of products in
multi-asset portfolios.
Cost
“If we are in a lower return world, then the cost on a
relative basis (active versus indexing) will matter more.”
A key catalyst to blending is the increased focus on low
cost solutions by clients, managers and IFAs.
Given the difficulty of achieving high returns in a low
return environment and the need to enhance risk-adjusted
returns through effective asset diversification, the costs
of investing are increasingly important. The low cost
structure of indexing products is therefore making
managers consider them increasingly attractive.
For large institutional pension funds, one manager
claimed that “in a nutshell, we do two things: Take active
fund risk where we think it makes sense, and do it as
cheaply as possible”.
Apart from minimising costs to the client, a benefit of
blending more index products into the investment process
is that net performance figures are higher. This was
referred to by a large discretionary client:
“The less cost we have, the better my performance
looks, compared to the index of course.”
While on the advisory side, businesses will have to “ justify
their existence post RDR as they’re providing a service,
rather than a transaction”.
Blending Insights: Catalysts
Catalysts
Blending Insights: Catalysts14
Performance of active funds
The relative performance of some active funds in recent
years was highlighted by respondents as another major
catalyst for indexing and blending. According to one
institutional asset manager:
“In the last couple of years not many active managers
have delivered, even in asset classes like high yield
and emerging markets, the areas where you would
expect that in difficult markets, active managers
would actually add value”.
Some predominantly active discretionary managers
described how recent years had made them consider
the use of index products as “we have seen a number
of years when active management has found it quite
difficult to outperform”. This view was shared by another

actively active asset management team who
commented that although they outperformed in 2008 and
2009, the top down thematic market of the last two years
has convinced them that blending has a role in their
investment process. One manager considering embarking
on blending stated that:
“Personally I am convinced that it is useful to have
active management, now and in the future, but the
experience in 2011 and, partly 2012, makes it clearer
that we should also have an important part of our
portfolio in the passive space.”
For many, 2008 is referred to as a watershed:
“Let’s face reality, you know, adding alpha post 2008
is more complicated.”
Growth in index product range
On the indexing side, the range of products has grown
sharply. As awareness and education has improved, it has
persuaded more teams to use them more broadly. One
multi-asset institutional manager felt a key driver for their
indexing usage was that over time “our knowledge on the
team about ETFs has increased”. This point was reiterated
by another large manager:
“I think the market has grown up to understand what
tool they’re looking for and then what the best
instrument to use is. So you can shop around seeking
a good passive fund.”
Business opportunity
The final catalyst we identified is the business opportunity
that blending can offer based on the potential price-
performance mix, and recognition of the gap between the
cost of active and indexing funds.
One discretionary business claimed that an attractive fund
proposition to them was a combination of active asset
class allocation, implemented through active funds and
index strategies at the right price point. “So, between the
two, a pure active or pure passive is an opportunity for us to
fill the gap with a range which played to our strengths.”
As the industry and client demand evolves, the business
opportunity of embracing a blending strategy within a
product line-up could be a key catalyst going forward.
What are the catalysts?
``
The key drivers of blending include cost, regulation and client-demand.
``
Client demand for lower cost, more liquid solutions is rising with greater awareness of indexing.
``
Regulation:
`–
For advisory businesses, especially in the UK and the Netherlands, new regulation is
changing the revenue model that has historically favoured active management.
`–
For discretionary, some regulators are seen as influencing the choice of products,
favouring more indexing.
``
The challenging post-crisis market environment has led to more strategic and tactical
asset allocation and hence a need for a broader range of products.
``
Relative performance of active managers in recent years and the growth of indexing
availability are contributing to greater blending.
Catalysts
15
Blending Insights: Trends in indexing and blending
Trends in indexing and blending
Trends in indexing
and blending
Blending Insights: Trends in indexing and blending16
While there are many factors that are influencing the way different respondents approach
blending, we can identify clear trends in the adoption of indexing and blending by
businesses and how these tools are being used.
Was the shift to blending or
index product usage strategic
or did it just evolve?
One crucial observation from our conversations is that for
many, this is something that developed – often out of one
experience. According to one discretionary manager who
has embraced blending over the past three years:
“It sounds strange, but there was not a time when we
sat together and said: ‘okay now we’re going to do
this.’ It more or less evolved.”
Often the decision to think more strategically about
blending was triggered by a specific investment event.
Several managers described experiences of 2007-2008
where due to risk management or investment opportunity,
they used indexing for the first time. A large multi-asset
institutional manager spoke of a confluence of events
whereby the combination of low valuations and new money
coming from a region where they had no manager research
capability, led to a growth in indexing usage.
One discretionary manager related how “all of a sudden we
realised that we had quite a substantial part in ETFs and
they performed quite well. Then the demand from the
private bank came as well. So the idea started to evolve that
we could offer a dedicated passive mandate.”
However, this is not always the case. One advisory firm
reflected on how their adoption of blending came out of a
strategic decision to re-think their product line-up and
shift to a fee-based model.
Where to use in discretionary
and multi-asset: core, tactical
or just ancillary?
In the discretionary/multi-asset institutional space, we
found that the way investors use indexing varies widely,
from full adoption of blending strategies to tactical asset
allocation to just cash flow management in a predominantly
active management mandate or portfolio.
Full adoption
Our
agnostic allocators have taken the step to
incorporate indexing as an implementation option across
all parts of their portfolios, core and satellite, strategic
and tactical. This might be either through fully-blended
portfolios or in indexing-only portfolios. Those participants
who are
embracing blending also tend to be
incorporating indexing into their core usage.
Tactical asset allocation
As we highlighted in <Catalysts>, a driver of blending has
been the growth of Tactical Asset Allocation (TAA).
Often we found that a positive experience in TAA was the
introduction to indexing and opened the door to more core
or strategic use across portfolios later on.
“If you place a high emphasis on tactical asset
allocation and think that this is going to be your
most important driver of active returns, then it might
make sense to actually not really spend that many
resources on selection, and use ETFs to express
your Tactical Asset Allocation.”
Trends in indexing and blending
Trends in indexing and blending
17
An
actively active discretionary manager, who is
considering starting blending, highlighted this as an area
that attracts them both from ease of implementation and
burden on operations:
“It’s very efficient for us to take a position,
underweight equity or overweight equity, with just
one product. Traditionally if I say I want to go
underweight equity and I have, for example,
35 individual stocks in my portfolio, I would have
to sell 5% of every stock.”
The same manager says they could see the potential to
grow index product usage in the advisory business as a way
to help clients implement the firm’s tactical calls. The
sentiment was echoed by a large wealth manager who
prefers to use indexing for tactical asset allocation,
especially for smaller clients given the cost.
A key benefit of using index products for tactical shifts is
the negative impact that frequent changes in allocations
have on active managers. Having a liquidity sleeve in
their portfolios enables the implementation of tactical
strategies, while allowing the active fund investments to
remain intact. This is particularly important as the active
strategic investments often have a longer time horizon.
According to one multi-asset institutional manager,
while you can trade in and out easily using indexing tools,
“you can’t give money to somebody you just appointed for
a benchmark plus three mandate and then tomorrow say:
I’ve a negative view on equities, and take your money away”.
Cash flow management
Related to tactical allocations is the need for discretionary
and multi-asset institutional funds to manage cash flows,
an area where indexing can be used as a buffer. Indexing,
especially ETFs, is particularly useful in this regard when
managers get notification flows into their funds after the
cut-off time to invest on that day. This was a particularly
common use cited by a broad range of respondents.
Notably it is also the one area where
actively active
managers who aren’t planning to adopt significant use of
indexing do use index products.
“The main reason for passive vehicles is to manage
flows and exposures, which you want to manage in
a very efficient, low transaction cost way, without
disturbing your active managers.”
Risk control – reduce tracking errors
in volatile times
A fourth specific use of indexing is in portfolio construction,
helping to control the volatility of a portfolio given a risk
budget. For example, one participant who manages
pension money described the value indexing brings to
them in controlling tracking error in a portfolio given a
certain funding ratio (the ratio of a pension plan’s assets
to its liabilities).
“So we use it a little bit to control that active risk,
to keep it within the parameters that are given,
either by the clients, i.e. risk-taking willingness,
and of course the funding ratio, which is the risk-
taking ability.”
Advisory is lagging
“It’s more difficult in advisory. In discretionary 35%
is passively managed. If you look at the advisory
portfolios you see around 5%.”
It is clear that the adoption of indexing and active
management together is at a more advanced stage in
the discretionary and multi-asset institutional world
than the advisory space. One obstacle to adoption in
the advisory space, the revenue model, is discussed in
<Challenges & Obstacles>.
Importantly, several advisory managers also highlighted
the competition to indexing from individual stocks and
bonds in the advisory space, as a result of clients’
preference for individual securities in their portfolios.
Where advisory indexing adoption has increased, is in firms
that have shifted part, or all, of their books to fee-based
models and developed discretionary-like model-based
advisory businesses. One advisory business drew our
attention to the fact that a key change in their business
was that active funds are now only included on their
recommended list if they are outperforming a comparable
index product. However, as we highlighted earlier, the impact
of this can depend on how centralised the decision structure
is within an advisory business.
Blending Insights: Trends in indexing and blending
Trends in indexing and blending
Blending Insights: Trends in indexing and blending18
Blending within product line-ups
When institutions think about building a process for active
management, indexing and blending, a key point to consider
is what the product line-up will be. We found that how a new
index-only or blended product would fit with existing
products was something that was not as well thought-
through as might be expected.
Broadly we found three approaches:
1. Mixing within asset classes within mandates: these
firms offer fully blended products where their blending
approach combines active fund and stock selection with
indexing within and across asset classes.
2. Mixing within mandates but deciding for each asset
class: these firms, while going down the blending route in
terms of offering a blended product, have generally decided
by asset class where to use active funds or indexing tools.
3. not blending within mandates: finally, some firms are
more comfortable offering active fund or indexing products
in their line-up. For example, they have launched an
indexing-only product to fit alongside an existing active
multi-manager product. One reason given was the difficulty
they felt in explaining why a product was part actively
managed and part indexed. By only offering non-blended
mandates the decision is put back into the hands of
the client so that “it’s not the firm that has to make
the recommendation”.
Trends in indexing and blending
``
While some firms have made strategic decisions to blend, for the majority it has evolved out
of one or two experiences.
``
Tactical asset allocation is a common entry point - often opening the door to full adoption
of blending.
``
The need to give active managers time to deliver leads all types of investors to use indexing
as a buffer for tactical or cash flow management.
``
The advisory business is lagging in blending partly due to the historical revenue model.
Where this is changing is for firms who are shifting to fee-based models. Competition to the
growth of indexing comes from the desire for advisory clients to hold traditional stock and
bonds, not just active fund management.
``
How an index-only or blended product is incorporated into an existing product line-up
requires forethought.
Trends in indexing and blending
19
Methods for blending
Blending Insights: Methods for blending
Methods for
blending
Blending Insights: Methods for blending20
For those who are

agnostic allocators or
embracing blending, the key question
has been how to blend. What struck us in conversations was the wide variety of ways in
which respondents have approached this question and the insights they have gained.
Broadly, we found that
agnostic allocators have
done the most investigation to find a theoretical solution.
What surprised them, however, were the conclusions they
reached: that there are no easy answers.
“I think the fact that we’ve tried to go all the way
down a very technical route and come all the way
back down to what is more a qualitative approach
has been a bit surprising.”
One manager examining the research on the topic
described their “key take-away as ‘it’s difficult to produce
alpha but not impossible”. Ultimately, the reality of the
importance of a qualitative or judgmental component in
any blending process was widely accepted.
Asset class efficiency
The most common factor driving implementation decisions
is the assessment of asset class efficiency. Which asset
classes are deemed efficient and therefore lend themselves
to indexing versus which are still inefficient and therefore
offer opportunities for active management?
There is a broad range of approaches to this efficient
market aspect of the decision: from in-depth internal
research, to relying on currently available external research
or high-level assessments, to just personal opinions.
Several multi-asset managers described their approach
as comparing active funds to the benchmark:
“If the peer group is all below the benchmark, over all
time periods, that doesn’t seem to be an opportunity
to go active. But when we see that a lot of active
managers of decent enough selection are
consistently above the benchmark, then we
recommend our clients to think about active.”
However, one manager highlighted the importance in their
view of a “forward-looking assessment of alpha on a risk-
adjusted basis” not just relying on historical performance
return comparisons.
While most have an approach of picking specific asset
classes to invest in via active management or indexing,
others are flexible in their investment approach within each
asset class. One participant felt that blending within each
asset class was a good way to manage that exposure over
market cycles.
Asset class trends
“If you really want to have true diversification,
you can’t just go down the passive route.”
What were the trends across various asset classes?
Plenty of disagreement illustrated the reality that there
is no one answer to blending, although there are some
common themes.
A summary of the key areas mentioned to us was as follows:
US equities
We were surprised by how often US large cap equities was
used as an example of an efficient market and therefore a
domain of indexing.
“So US equity, I continue to make the case related
purely to the dispersion within large cap equity. Given
the difference between the best performing stock
and the worst performing stock, you’d have to get it
extremely right as an active manager to add
significant value over the index.”
However, one multi-asset institutional manager saw an
opportunity to blend within the market “a high income
paying active manager with a passive vehicle”, while a
predominantly active fund-focused manager still felt they
could find alpha.
Methods for blending
Methods for blending
21
Blending Insights: Methods for blending
Fixed income
In fixed income the arguments were more divided.
In the government bond space, one discretionary manager
felt that given the low yields, the focus needs to be on cost
reduction. Interestingly several highlighted that while
European government bonds had been a place for indexing
over the past decade, it was undergoing sufficient change as
to warrant a re-think as to whether active management may
now deliver better risk-adjusted returns.
High yield credit and emerging market debt were cited by
several respondents as lending themselves more to active
management “because basically you want to manage the
default risk”. However, in the investment grade space it was
more mixed with views ranging from one manager’s opinion
that “a US investment grade manager can’t add that much
alpha” to another’s view that “you can still add value on the
corporate side by doing proper selection”.
We also heard more generally of difficulties in using indexing
in fixed income relative to equities which we explore in the
<Obstacles> chapter.
Emerging market equities
Many respondents used emerging market equities to
illustrate their views on efficiency. Broadly, this is an area
that people feel should offer opportunities for managers to
outperform the benchmark. However, one manager sees
this changing as emerging markets evolve:
“To be honest in EM equities, we’re moving more
towards the passive side, but historically we thought
EM equities as an area where we can add skill.”
In describing their approach to emerging markets, a
discretionary manager differentiated between broad and
country exposure. “If I want to play emerging markets on a
global basis, an ETF can be good.” However, to invest in
countries like Indonesia and Vietnam he would prefer an
active mutual fund as he felt the “liquidity will be better
managed by the mutual fund manager”.
Alternatives
Finally, in the alternatives space we found a mixture of
views. The multi-asset manager, who earlier highlighted
the difficulty of using just index products for true
diversification, used the example of property where they
believe it “simply can’t be managed on a passive basis”.
In the commodities space the range of views was more
diverse. Two large multi-asset managers felt the key to
commodity investing was the commodity market rather than
stock selection skills, whereas one disagreed, saying that for
them, “commodities should be just through active funds”.
Not just asset class views –
other issues
“I think it’s very important to know what asset class
we are talking about, what time horizon we have,
and do we really have best-in-class managers in that
peer group.”
Some respondents argued efficiency was not the most
important consideration – that availability of a good
manager was more important. A static or dynamic process,
the time horizon for the investment, and how an investor or
end-client values liquidity can all play a key part in the
blending decision process.
Finding good active managers
“Anyone who says to you: ‘UK equities is a very
efficient market and that’s why I’m entirely in
passive’, just hasn’t done any work behind that”.
For some, not relying on an asset class efficiency view
but on whether there were good managers is essential.
One manager gave the example of high yield where,
having highlighted it as a market that lent itself to active
management, said “if we didn’t have any managers that we
believed could outperform the benchmark, then we wouldn’t
invest actively in the high yield space”.
Static or dynamic?
“We will make that decision at that particular point in
time, and then decide whether to go active or
passive, but it’s a function of time. The decision to go
passive in US/UK small cap today is not going to be
the same as the decision three years down the line.”
While some respondents make decisions on where to
use active funds or indexing vehicles over the long-term,
others stressed the need for a dynamic decision process.
The market cycle was highlighted as a key driver of these
blending decisions as different cycles have different
implications for overall returns and active relative
performance. As noted earlier, one example given was
European government bonds.
One participant highlighted fixed income as a place of
regimes where “during long periods of time, when ratings are
relatively stable, investing in the index is the best way” but
noting other times when active management was required.
Recognising that your process may require a dynamic
element doesn’t make it easy:
“I think that we’ve been doing this long enough to
know there are cycles in alpha generation. But it’s
very hard to time.”
Methods for blending
Blending Insights: Methods for blending22
Time horizon
The time horizon of any given investment is another factor
in the blending decision. There is a need to give active
managers “time to play out, because of the cyclicality of the
excess return that is produced by the manager”, though
interestingly there is little consensus over how long that
should be.
In general, the shorter or more tactical the investment,
the more likely investors will choose the indexing route,
while for longer investments, more investors are inclined
to consider active funds.
“If I want to invest in a total return fixed-income
portfolio for the next three years, I will go into an
actively managed portfolio, because they will avoid
a lot of the things you don’t want to see that are
sometime in indices. If I want to tactically play a bond
index, I’m definitely going to buy the ETF. If I want to
play views on high yield in the US for the next two
weeks, I’m going to buy the ETF.”
Liquidity
The question of liquidity, in particular intra-day liquidity,
got a more mixed response in terms of its importance in
portfolios and blending.
“I would say that it is reasonably important because
funds are fixed pricing and you’ve got to tell them
four hours before you want to deal and anything can
happen in those four hours. So from that perspective,
ETFs are a good use of being able to use liquidity.”
As with other aspects of the blending decision, the client
mandate plays an important role:
“We are still talking about pension funds, by their very
nature, they’re very long-term investors. So I think it’s
not been necessary yet to use the daily liquidity that
ETFs provide.”
Investment size
Sometimes the relative size of an investment within a
portfolio drives implementation in whatever is the quickest
and easiest way.
“If it (our model) only wants 3% in corporate bonds,
we’re not going to split that three. We’re not going to
mess around; we’ll just shove it all into passive. So
practicalities will also drive some of the decisions.”
What methods are employed for blending?
``
There is no single answer to blending.
``
Blending methodologies are a mixture of quantitative analysis and qualitative judgment.
``
Asset class efficiency is the most common starting point for blending decisions. While there
are trends, there is little consensus on which markets are the most efficient.
``
Some feel blending should be more dynamic, based on what is available for that exposure at
any given time.
``
Market cycle, the investment time horizon and size of any given investment are cited as
key considerations.
Methods for blending
23
Challenges and obstacles to blending
Blending Insights: Challenges and obstacles to blending
Challenges and
obstacles to blending
Blending Insights: Challenges and obstacles to blending24
Blending active funds and indexing strategies does not come without challenges.
Ranging from product specific obstacles to broader changes in mind-set, these need
to be overcome to get the most effective use from blending.
Challenges and obstacles
to blending
Changing a mind-set
“I guess philosophically as managers, this desire to
push up the active weighting, but hitting into the cost
constraints, that’s going to be an interesting one to
see how that plays out.”
Introducing indexing instruments into a historically active-
manager-only investment process did not come naturally
to some of those with an active management background
(those who have moved from being
actively active to

embracing blending).
According to one discretionary manager who has evolved a
blending strategy, “it will be a challenge for those who have
set their stall out on being active managers”. Having added
indexing-only and blended products to their traditional
multi-manager product offering, the same manager
commented on one of the key differences with indexing
instruments: the lack of an “emotional attachment to them,
like you do with active funds and active fund managers”.
Whereas with indexing, you are a lot more willing to sell the
investment, “investing with a manager is an emotional thing,
you are making a commitment”. Harnessing this ability to be
more active around allocations, to think more often about
when to move, is “going to be a challenge because I’m so
used to being a long-term investor”.
Interestingly the same manager observed the danger of not
bringing the fund selection team with you. While he could
“now afford to look for managers that are even more
concentrated than normal” in his new blending strategy, the
fund selection teams were probably still focused on finding
“good funds in general”. As such, his challenge was “to
educate them, on what’s required in a portfolio and the way
that we’re thinking on the portfolio front”.
Having an in-house manager
A second obstacle raised was the potential issue of
having an in-house active manager business which could
create pressure to use internal funds. One discretionary
manager reflected:
“I remember in the past we had our own asset
manager, it was more difficult, there was always
a little bit of an internal conflict when you go
open architecture.”
Some respondents noted that for them the introduction
of blending was “not difficult” because they either didn’t
have in-house funds or felt under no pressure to use
them. We also found that many of their clients anyway
limit the amount of in-house funds they are happy for their
portfolios to hold.
One participant with in-house funds noted that, while it
can create profit and loss issues across the businesses,
it “cannot influence the investment decision”. However,
they agreed that it is a sensitive issue, especially when
taking money away from a manager with a good track
record because of an asset allocation decision. In this
regard, communication and stakeholder management
internally was seen as critical. “So it’s just communicating,
making sure everyone understands what we’re doing and
why we’re doing it.”
On the opposite side, there are benefits to having in-house
funds. For one discretionary manager with an investment
philosophy requiring transparency, using external vehicles
is a challenge. That doesn’t mean they won’t do it “but it
means that the hurdle to get us to do it is that bit higher.”
For others, in-house funds can bring a cost saving,
benefiting their end clients.
Challenges and obstacles to blending
25
Blending Insights: Challenges and obstacles to blending
Advisory revenue model
One specific obstacle to indexing and blending in the
advisory business is based around the rebate revenue
model. Many advisory respondents highlighted the
difficulty in promoting indexing through their distribution
channels where they are still reliant on a rebate paid to
them by mutual fund providers.
Notably, while in other European countries the revenue
model of advisory could remain a significant obstacle to
blending, several advisory businesses in countries such as
Germany and Israel told us they are already making a shift
to fee-based advisory for new clients. This was occurring
even in the absence of formal regulatory changes.
Communication
For those that launch new indexing-only or blended
products, communicating to end clients around the product
line-up is critical. Some
actively active who are
considering this move worry about how existing clients in
active management-based portfolios will perceive it:
“One of our struggles is if we start using indexing, we
change the propositions we made to our clients. And
the story we tell them right now is… we have a great
team which picks the best fund managers. If we then
say: for part of the portfolio we are using passive
products, that’s a different proposition.”
Conversely, a manager of an indexing-only product
highlighted the difficulty given his firm’s “active
management house” image with end clients. So “when it
comes to marketing our passive products there is not the
same level of support as there is for the active products”.
Selling a story
From a sales perspective, having a story that you can sell is
key. There is a view that the active management story is
easier for many salespeople, especially those used to
selling only active funds.
“What I see relationship managers (RMs) asking me is
a story of the fund. It’s easier certainly to come up
with a story for an actively managed fund than for a
passively managed one.”
Furthermore, while cost can be a driver for using indexing
within a fund, many salespeople “don’t want to simply say
we use passives to keep the cost down; they want there to be
more of a story around them”.
However, others feel that the story of indexing is now
evolving with the regulatory changes and recognition of the
importance of asset allocation. For advisors, “there is a
story now, the story is the adviser is no longer transactional,
by and large, and therefore the adviser has to offer a service,
and passive is part of that service”. For many asset
allocators the key was educating the salespeople to
sell asset allocation rather than a product:
“If you’re selling an ETF, you’re selling asset
allocation, because you’re just getting beta exposure.
You can’t sell the ETF. You’ve got to sell the beta
exposure, and that’s a very different sell than,
‘I got this sexy product’.”
Scaling
Scaling a large blended asset allocation discretionary
business across countries is operationally challenging.
According to one global wealth manager, while the asset
allocation element is straightforward, “what makes it
exponentially difficult is the implementation due to all of the
restrictions you might have from a registration perspective,
from a tax perspective”.
Availability and structure
of indexing
For managers who have embraced indexing within
portfolios, one of the obstacles to greater usage is the lack
of available exposures. According to one asset allocator,
“sometimes it’s frustrating because those vehicles don’t
always exist”. This was seen as a particular barrier in fixed
income where investors were constrained by indices not
being available and being weighted only to the amount of
debt outstanding.
The lack of availability of indexing was not limited to the
existence of exposures, but also access to existing products
in the advisory space. IFAs in the UK can find it difficult
to access ETFs on fund platforms, while in wealth
management, the short-track records of many ETFs
make them difficult to promote.
Education
A further obstacle is the lack of education on indexing
instruments. According to one discretionary manager:
“90% of the clients don’t know what a tracker-only
index fund is, certainly in retail they don’t know what
it is. So there’s a lot to do about education, explaining
what it does for them.”
One predominantly active fund-focused manager argued
that clients, who were less informed than others, were very
much driven by price alone, which led them to choose
indexing exposures. They failed to ask themselves the
question if they could be better off by paying more?
Challenges and obstacles to blending
Blending Insights: Challenges and obstacles to blending26
Operational challenges of
using ETFs
Five obstacles to using ETFs were commonly cited:
1. Trading eTfs is something most have had to learn given
their differences with mutual funds. One manager’s trading
system made it difficult to get the best from ETFs with
multiple trading lines as it “doesn’t look at which market is the
most liquid”. As a result, they preferred to use index funds.
2. Tracking error: explaining ETF tracking error to clients
was something respondents didn’t expect to have to do:
“Another thing which was a surprise for me is that
there can be still quite a deviation in terms of
tracking error. And maybe people don’t realise that,
people don’t understand that so we really have to
explain to them how it works.”
3. eTf data was raised as a “real problem” for some.
System issues centre on the difficulty to look-through to
actual exposures on internal risk-systems or the fact that
internal administration systems “can only use index funds
instead of ETFs” as one participant found when they
started to look at using ETFs.
4. Internal approval for ETFs was a greater challenge than
expected for one discretionary business that had moved to

embracing blending.
5. Due Diligence for ETFs is different to that required for
active mutual funds. Several respondents highlighted how
“due diligence changes with a big focus on the ‘operational
side’” when introducing ETFs. This business found a
“culture clash having mutual fund analysts looking at ETFs”.
One global wealth manager felt strongly that “this notion of
structural due diligence is a very important aspect, and there
are still a lot of market participants that ignore that”. The risk
is that people are attracted to ETFs they don’t understand,
which can raise issues of suitability for advisory clients.
What are the challenges to blending?
``
For the advisory business, the biggest obstacle is the rebate-based revenue model prevalent
in most European countries.
``
For those from an active management background, blending effectively can require a shift in
mind-set; there is less emotional attachment to index products.
``
In-house asset managers can be a challenge, especially when switching funds, yet can be of
benefit given the additional transparency they offer relative to external funds.
``
Selling blending or indexing is different to promoting an active management story;
communicating to clients around the product line-up requires thought.
``
Lack of availability or understanding, and the operational challenges of using indexing
products are obstacles to greater adoption.
Challenges and obstacles to blending
27
Lessons on indexing and blending
Blending Insights: Lessons on indexing and blending
Lessons on indexing
and blending
Blending Insights: Lessons on indexing and blending28
As we conducted our conversations with respondents, we asked them: what lessons did
they learn? The advice they gave ranged from what they learned about their client base to
how to engage in blending most effectively, and why index products can be useful
investment tools in multi-asset value propositions.
Lessons on indexing and blending
Focus on your clients
“You’ve got to think about your own clients first. It’s all
about the returns, rather than having a philosophy.”
Staying focused on what your client needs is critical to
get the best out of blending and indexing. As our
respondents noted:
1. Don’t be scared that clients won’t accept blending.
2. Introducing indexing is not self-explanatory:
communicate what you’re doing and provide the same
level of service as your clients would expect in active-
only management.
3. Think ahead about your product line-up.
4. Always keep in mind the cost factor.
Keep an open mind
“I’m an active guy; I grew up with active management.
You do passive if you can’t do active. I really changed
my opinion on that. One needs to keep an open mind
on what makes sense and if there’s no way to make
money in an active class, then swallow the pill and
go passive.”
1. Don’t think of indexing products as competing products –
it’s possible to find solutions where active funds and
indexing can work together.
2. Consider all the options available – to assume an asset
class is already efficient might result in missing an
opportunity to invest in a successful active fund.
3. It’s a constant learning curve: from understanding the
products at your disposal to learning how and where to
use them and how to switch between them. Don’t try to
be too prescriptive.
4. In indexing, operational considerations are critical.
5. Deciding which index product to use can be difficult;
evolve a process for this.
6. Implementation is crucial – get the right skillsets in place.
7. Stakeholder management is essential.
What advice would our participants give?
``
Communication is key: both internally and to clients.
``
It is a learning curve; operational, implementation and cost considerations are critical.
``
Stakeholder management is essential.
Lessons on indexing and blending
29
Looking to the future
Blending Insights: Looking to the future
Looking to the future
Blending Insights: Looking to the future30
The final aspect of our conversations related to our respondents’ thoughts on the future
of blending. Their outlooks unveiled some thought-provoking insights not just about the
future of blending and indexing but, about the asset management industry in general.
Looking to the future
Fee compression
“One thing is quite clear, that we will see pressure on
prices, on margins, in our business.”
Cost pressure is tangible and the majority of our
respondents feel that that pressure will continue to grow as
we see fee compression across all parts of the asset
management industry.
On beta, one discretionary fund believes: “If you can’t get
the market returns, you think twice about how much fees
you can give away.” While, according to another: “There is
pressure on the active side as well. I think you will see for
the next couple of years that margins on the active side will
adapt more towards the passive vehicles, because otherwise
they will lose business, even if they are good.”
An intriguing question that was raised was what happens if
the costs of using active funds and passive vehicles
converge. So, “if pricing is the same, if there is no difference,
do you want to go for active or do you want to go for
passive”? This manager felt that such a situation would
make it more difficult for index products. Others felt that
even if the costs were similar, that wouldn’t necessarily
mean choosing active funds for every exposure.
As well as fee levels, transparency of fees is something that
will increasingly become a focus.
“We built the business on being clear and
transparent, so we haven’t actually changed our
approach very much; I think the market has moved
more toward the way we have always done things.”
Advisory business model
The advisory business model is going through a time of
change, driven primarily but not exclusively by changing
regulation. Two potential trends were highlighted:
Level Playing Field
“In the RDR world, active versus passive becomes, as
far as the industry is concerned, a much more level
playing field now”.
Without rebates “it doesn’t matter what kind of product
you take, you will look more at the total performance of
your portfolio and for the beta components choose the
cheapest solution”.
One advisory business also emphasised the impact of the
end of rebates on internal costs. “It costs a lot of money to
have a research team”, such that in a world without trailer
fees, “the temptation is just to use some ETFs”.
Barbell to discretionary and execution-only
The second trend is a potential client shift from advisory
towards execution-only and discretionary businesses as
advisory starts to employ a fee-based model. Given the
greater adoption of indexing vehicles in these two areas
relative to advisory, this shift could significantly increase
blending and indexing usage.
“The fear is that once you start moving towards an
advisory model, a lot of our advisory clients will say:
‘well, in that case, either we’ll go to discretionary or
the execution-only option. We’re not willing to pay for
the advisory, unless you can prove that you add value
on the advisory side which is worth paying for’”.
Several respondents in the UK wealth space believe that
discretionary will be a beneficiary of UK RDR. According to
one head of wealth discretionary, bankers will migrate their
business to discretionary because “their book is much more
scalable if they have us manage the money, rather than
needing to contact the clients all the time to generate revenue”.
He believes that one of the key drivers is the operational
complexity and overheads new regulation will bring to the
advisory business. “(UK) RDR actually implies a lot more
work, in terms of paperwork for a banker.” The higher burden
of process management, of proving communication and
therefore greater cost overheads, doesn’t exist for
discretionary portfolios.
In fact the trend towards execution-only platforms leads
one wealth manager to believe that the level-playing field of
UK RDR won’t necessarily drive indexing usage up in the
advisory space itself:
Looking to the future
31
Blending Insights: Looking to the future
“I don’t think we’re going to see a massive take-off in
advising passive products because if you look at the
industry trends, the biggest growth in custody assets
has been on execution-only platforms.”
Future of active fund management
“So the small percentage of active managers that
have great track records will get piles of money and
the majority of them won’t.”
Squeezing the “middle ground”
Across our respondents we found a strong consensus that
the middle ground of active funds, or index huggers as they
were referred to by one manager, will ultimately lose out to
a barbell shift towards cheap indexing for beta and high
active, “benchmark plus two or three”, for alpha. Notably
this was a view shared by those who are heavily engaged
in blending from
agnostic allocators to those who
are
actively active and not looking to embrace blending
or indexing.
We heard consistent comments that “sub-scale funds
with poor track records” won’t be around for long, as
investors focus more on finding “exceptional managers,
who invest money in a slightly different way and think less
about indices”.
One institutional multi-asset manager who says he can just
get beta from indexing, is looking to mix that with “bigger
active bets”. He feels that if he is going to pay up for active
management going forward he “wants to pay for someone to
take real risk”.
In advisory, one large wealth manager said:
“When you brainstorm into the future everything
that’s going to be strategic, where there is alpha to be
added by active management, we will continue to
have a very strong mutual fund offering. Everything
where it is very difficult to add alpha, what I would
define ‘the plain vanilla world’, I think there will be a
trend towards ETFs.”
Or will active management rebound?
However, some investors warned about extrapolating the
recent market cycle into the future:
“After 2008, everyone was talking about ETFs
because in 2008 active management failed. But they
forgot they had tremendously outperformed for ten
years prior to that. That’s how human behaviour is.”
“We think the likelihood of active managers not
delivering again for the next ten years is lower than it
was for the last ten years.”
Evolution of indexing
A key question asked by several participants was that of
“what is indexing?” In particular, the point was made
around the “active” aspect of asset allocation:
“So some people are set in their ways, they only do
passive. What they don’t realise is that’s an active
decision and quite often they say ‘we only do
passives’, (but) their asset allocation is active.”
Another active-management focused manager raised the
issue of index choice. In his view choosing a specific index
within a given exposure for an index product to track, was
making an active bet.
Looking forward, there is a sense that this question will
become increasingly important. One institutional manager,
who is a large user of indexing products, believes “you’re
starting to see the fragmenting of what we mean by ‘index’
and therefore what we mean by ‘passive’”. He argues that the
market is evolving to a point where indexing doesn’t equal
cap-weighted. Ultimately in his opinion, passive or indexing
will come to mean “replicate some strategy without deviation.
Simple, transparent, I can go out and easily construct a
reference so I can track what you’re doing”.
Others are more sceptical of too much innovation.
Commenting on active index products, a multi-asset
institutional manager said that in this view index products
are building blocks. Having simple building blocks is better
for creating complex investment solutions:
“So if you know exactly what ingredients are going into
your cake, you can get a very powerful cake. If you’re
putting in ingredients that are bundled up and mixed
up already, you’re not really going to be sure what your
cake’s going to taste like.”
Risks to further growth of indexing:
As well as the evolution of indexing, we heard warnings
of the potential risk to further growth should an index
product go wrong. Regardless of what type of product
it was, it would “hurt the whole industry potentially”.
One
actively active manager went further, predicting
that current misperceptions about what indexing products
deliver will result in major disappointments for investors.
“So I think there will be a lot of bad experiences for
these guys in passive investment, because the
understanding is still poor.”
Looking to the future
Blending Insights: Looking to the future32
Blending: the short and
the long-term
Going forward, most expect continued growth in blending
and indexing. One manager with a blended product
described it as the “sweet spot”:
“We do think that in time, that blended will be the
range that we sell the most of. That combination of
value for money, plus the active overlay, plus the
active fund selection, that combination is the sweet
spot of what everyone wants.”
One institutional multi-asset manager felt strongly:
“We as a multi-asset desk have been hurt by
active investments. Fees are still quite high in the
industry and given those two things, active doesn’t
work. I think diversified beta is going to make a
strong emergence and that’s where the industry
is heading.”
In the advisory world, the issue of suitability given the
range of ETFs available remains an issue, however: “In my
opinion we are just at the beginning and we just need this
notion of client suitability, and to understand to whom we
can sell these ETFs.”
A key point to note, though for firms operating across
countries is the difference in uptake as according to one,
“we’re probably heading in the same direction but at a
different speed”.
But it’s not all one-way. There is a strong view, especially
amongst those
actively active respondents with strong
conviction in active management, that people will pay for
performance, as they feel they have “been able to convince
our clients that active is worthwhile paying for” and are
confident they can continue that success. One felt that
once market conditions normalised that usage of indexing
would drop back again, while several respondents put
forward the notion of a tipping point:
“People have moved slowly into passive. I think
they will keep moving into passive even if active
management delivers, then at some stage the
pendulum might swing back.”
Further, we shouldn’t forget the importance of the
interaction between active management and indexing.
The liquidity provided by active management was
highlighted as a key ingredient to allow indexing to deliver
beta in a cost-efficient way. Far from being an either/or,
these differing ways to get exposure to markets are
intertwined more than ever.
What of the future?
``
Likelihood of continued fee and margin compression across the industry.
``
High level of consensus for a shift away from the “middle ground” of active management.
``
Indexing will continue to evolve to mean more than just market-cap weighted.
``
In advisory, changing regulations will create a more level playing field for indexing and active
management and see a barbell shift by end-investors towards discretionary and execution-
only services.
``
Blending and indexing usage will continue to grow – but there may come a tipping point where
increased opportunities for alpha may trigger a reversal back towards active management.
Looking to the future
33
Blending Insights: Conclusion
Conclusion
Conclusion
Blending Insights: Conclusion34
In this paper we have attempted to convey current thoughts around active and index product
blending by professional European investors. From the interviews with our respondents, it is
clear that this is a multi-dimensional subject of great interest, debate and trepidation. There
is no one answer to blending; no consistent methodology that can be applied across the
industry. For those deciding whether to journey down the road of blending, the influences
and challenges that teams and institutions have to consider are many.
Our participants expect more change ahead: fee and margin compression, the squeezing
of the “middle ground” of active, and the evolution of what indexing means. Ultimately
most expect the catalysts that have driven changes in the industry thus far are likely to
accelerate the pace of blending going forward.
Conclusion
When reviewing their active and indexing blending approach from both an investment and
business perspective, firms could address these questions.
Key questions to assess your current position
1. Of the three identities discussed in this paper, which resonates closest to your current
approach towards active and index blending?
2. How effective is your current blending strategy?
3.
Do you feel you have arrived at your current state strategically or more through evolution?
4.
Which catalysts have played a primary role in your current approach to blending?
looking forward: will your future look like your current state?
1.
When you look ahead, what would you like your approach to blending to be?
How will this differ from your current stance?
2. If you see your approach to blending evolving, which identity might you target as
your destination? Why?
3. What is required for you to get there?
4.
Are there specific asset classes where you would be more likely to consider blending?
5.
What challenges do you believe you will encounter?
6.
Will your value proposition to your clients need to evolve? If so, how will you communicate this?
Conclusion
Looking forward: key questions to consider
Blending Insights: Editors
35
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