Index managers take big hit in markets this year

This year has been tough for markets. Equity and fixed-income investments are down about 15% year-to-date through Nov 4. The sell-off has hit everyone, including index managers, which saw a significant decline in assets under management.

Worldwide indexed assets under management declined 12.7% to approximately $18.23 trillion through June 30, compared with $20.88 trillion a year earlier for money managers that participated in Pensions & Investments' annual survey.

The largest providers — BlackRock Inc., Vanguard Group Inc. and State Street Global Advisors — all continued to dominate the top slots within the P&I universe; however, all of them recorded declines.

BlackRock remained in the top spot despite a 12% decline in AUM, with total indexed assets of $5.53 trillion as of June 30, increasing its lead over Vanguard, but down from $6.3 trillion a year prior.

As of June 30, Vanguard's indexed assets totaled $5.26 trillion, down 16% from $6.25 trillion a year prior. State Street had $2.87 trillion through June 30, down 12.5% from $3.28 trillion last year.

"Everyone had challenges over the first half — particularly on the fixed-income side," said Tyler Cloherty, Stamford, Conn.-based managing director at consultant Casey Quirk, a part of Deloitte.

"Index providers which have pure beta market exposure as their largest offerings fell with the broad market indexes — the drawdown was heavily correlated for them. No one was spared."

Markets have rebounded slightly from the steepest point of the sell-off, but the second half of 2022 has still been volatile. Mr. Cloherty expects that the pressure on index providers will continue and could carry into 2023 if recession risk remains elevated.

"Going forward, there are challenges for index managers from a competitive standpoint in this environment," Mr. Cloherty added.

"We're on the back of a 10-year cycle where markets had been really tightly correlated, so owning beta made a lot of sense when everything was moving up together. Now that's breaking down, so investors are taking a fresh look at their portfolios and rethinking their approach."

In practice, Mr. Cloherty said broadly diversified passive indexes are likely to remain as the core holding of institutional portfolios but the role of actively managed funds is likely to increase and investors may expand allocations to different parts of the fixed-income universe that were previously out of favor.

Institutional investors are considering high-yield and shorter-duration bonds as well as opportunistic strategies that move in and out of different bonds based on market signals.

Equity strategies that are more tactical in nature also are getting a closer look as investors think through how to navigate volatility, Mr. Cloherty said.

John Delaney, senior director of investments and a portfolio manager at Willis Towers Watson PLC in Philadelphia, agrees.

"What we've seen is asset owners look a little harder at their passive exposure and focus more on active strategies. On the equity side, there are five or six companies that really dominate those passive indexes," he explained, noting that there could be heightened concentration risk in a volatile market with only a few companies accounting for the largest weightings in an index.

"Investors are looking for ways to build diversification into their portfolios, and there is a view that actively managed strategies might be able to provide value in more volatile markets — both on the diversification point and being more opportunistic within strategies," he said.

Mr. Delaney added that beta exposures could rebound if markets get a little more certainty on central bank policy and its potential impact on markets, but it's too early to tell.

"We see the need for active management over the next 12 to 18 months," he said. "If we get a more supportive bank environment, then we might see beta exposures rebound, but we aren't there yet."

If those forecasts hold true, asset flows going into 2023 would be the inverse of 2022. Matthew Bartolini, Boston-based managing director and head of SPDR Americas research at SSGA, said that despite drawdowns in both equities and fixed income, the bulk of SPDR's asset flows so far this year have been to core beta exposures.

Year-to-date through Oct. 28, "ETFs have (had) over $507 billion of inflows. That puts us on pace for the second largest inflows for a calendar year, just behind last year's $900 billion gargantuan haul. This is largely led by passive low-cost exposures that are used in strategic asset allocation. Much of the outflows we have seen are coming from active (ETF) strategies," he said.

SSGA managed $986.24 billion in ETFs and exchange-traded notes as June 30, down 4.73% from the previous year, according to P&I's survey.

The other place Mr. Bartolini is seeing outflows is from mutual funds. This trend is not new, as mutual funds — especially actively managed mutual funds — have seen outflows for a number of years. That trend could be exacerbated by market volatility, and when investors exit mutual funds, market data shows they tend to pivot to ETFs, both active and passive depending on the mutual fund strategy they are replacing. Overall total cost of ownership for ETFs is typically lower than mutual funds and they are easier to enter and exit. For investors that trade actively, being able to enter or exit an ETF intraday may be worthwhile, he said.

"There is the potential for multiple bad outcomes to hit mutual funds," Mr. Bartolini said. "Mutual fund managers are going to be down on the year, they are going to underperform their benchmark, and historically almost half of active mutual fund managers have paid capital gains tax in a given year. Typically, when there are outflows, the percentage of funds that pay capital gains go up. So investors are going to be down compared to the benchmark and get hit with capital gains dividends. That's not a great outcome."

Daniel Reyes, Philadelphia-based principal and global head of investment product at Vanguard, added that against this backdrop he anticipates that advisers and investors of all types will start looking closely at ETF share classes — especially if mutual fund providers offer similar strategies in an ETF wrapper like Vanguard. "The benefits of ETFs — specifically the tax efficiency and ease of use — are becoming clearer to all types of investors," he said. "There are still a number of circumstances where mutual funds make sense, but the trend we have observed so far is a movement toward ETFs and we anticipate that will continue."

Vanguard led the P&I survey for institutional tax-exempt assets under management with $1.43 trillion as of June 30, down 14.9% from $1.68 trillion a year earlier.

Collective investment trusts also continue to be a growing market for index managers, Mr. Delaney said. Defined contribution retirement plans and large institutions have turned to CITs for customized managed account solutions that often have lower fees.

WTW's Mr. Delaney said recent regulatory updates for 403(b) defined contribution plan sponsors makes it easier to use CITs as a retirement offering.

"We have been getting more questions from 403(b) plan sponsors for education on CITs because this is obviously a new area for them," he said. "Those requests could lead to an uptick in CIT adoption down the line."

Thematic funds may also get a future boost from endowments and foundations. Mr. Delaney noted that a growing number of endowments and foundations are thinking through ESG strategies — specifically those that track carbon neutrality and sustainability. This, too, is still at an early stage with most groups looking for advice and education.

"We might see indexing take a percentage as those groups work through what their strategies will be as that is already the case in other institutional portfolios," Mr. Delaney said.