Legal & General Investment Management’s Colm O’Brien and Dan Attwood on the company’s ‘pragmatic replication’ process boosting its £330bn portfolio of index funds
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Legal & General Investment Management (LGIM) is one of the world’s largest asset managers with index at their core, but its growing portfolio of index funds is more than just replicating the markets. Colm O’Brien, Head of Index, EMEA, explains how the company’s targeted and pragmatic approach to managing index funds aims to provide investors with the best-value exposure today. With two named managers on each index strategy, O’Brien details how the team aims to exploit inefficiencies to generate returns for clients. Meanwhile, LGIM’s head of retail propositions, Dan Attwood, analyses where the sector is heading and how new regulations could impact its fund range.
To the uninitiated, running an index fund might seem the simplest thing on earth. By definition it involves keeping in step with the fluctuations of the chosen index. How hard could that possibly be?
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The common sense approach to investing
Colm O'Brien,
Legal & General Investment Management
Index range expansion
Minimising risk
Distortion control
Pragmatic replication
When faced with this kind of distortion, LGIM aims to be smart about phasing the fund’s investment over time. This allows it to avoid periods where prices seem artificially squeezed, says O’Brien. He cites the recent example of British American Tobacco’s merger with US firm Reynolds. That event increased BAT’s weight in the FTSE All Share Index by nearly 1%, requiring index trackers to acquire more shares. “We made sure we implemented that in our UK Index Trust as efficiently as possible, by phasing that trading over a longer period,” O’Brien explains. “We also cross-shared the trade with our US funds, minimising the costs of the transaction and adding value for our clients. That allowed us to add nearly two basis points for our clients invested in funds tracking the FTSE All-Share Index." LGIM believes in keeping it simple when it comes to additional risks. Unlike many fund managers, it does not take part in stock lending for its retail index funds and prefers to only use derivatives for efficient portfolio management purchases. Alongside its constant scrutiny of the market, LGIM also keeps a close eye on the behaviour of the companies within each of its indices. “We are keenly aware that when stocks are in an index, investors can’t just sell them – they are long-term holders of these companies,” O’Brien says. LGIM has also developed a proprietary scoring tool to analyse the environmental, social and general business impact of fund companies. As the biggest provider of UK index funds, and one of the world’s top 10 asset managers, it uses its scale to influence and engage with companies over the long term, while managing conflicts of interest. “We believe it’s our responsibility as the investment manager to make sure the companies our clients invest in are run properly, and held to account. “We invest heavily in our corporate governance team, to make sure these companies are run for the benefit of our clients,” O’Brien adds. LGIM is looking to extend this successful approach with new offerings over the next year. “We constantly look to evolve and bring new products to the marketplace. For our retail clients, we’ve recently launched a range of ICAV products, and we’re looking to extend that significantly over the next six to 12 months,” O’Brien promises. “We’ve also seen a significant growth in factor-based investing – we believe we can bring relevant products to the UK retail market soon.”
Colm O’Brien begs to differ. As Head of Index for EMEA at LGIM, he oversees the company’s £330bn invested in index tracking strategies, and he is clear in his assessment of investing: “There are many different ways to run an index fund.” LGIM has a term for its own favoured method: “pragmatic replication”. What this means in practice, says O’Brien, is a common-sense approach to achieve efficient tracking at a low cost to investors. “We really try to leverage any index efficiencies, to add value for our clients,” he explains. While LGIM sets out to achieve something close to full replication for its index funds, what sets it apart is a willingness to hold back where market conditions don’t allow it to buy or sell a share for a fair price. In those cases, LGIM uses a measure of sampling until liquidity improves. Individual weightings are allowed to fluctuate within a narrow band, consistent with each fund’s target tracking error. This minimises unnecessary rebalancing – and the associated transaction costs. For some of its funds in this range, the firm uses a more traditional sampling technique. This is mostly done in funds tracking bond indices, though it can also be used in equity funds too, depending on the features of the specific market. Whatever the fund, strict risk parameters control any deviation from the benchmark. One of the most challenging events for index fund managers is the periodical rebalancing of the benchmark indices that the funds are designed to track. This often unleashes a frenzy of activity as many investors seek to buy and sell those securities on the same day, leading to price distortions.
The next investment cycle
Fund range snapshot: Meet the managers
LGIM Index Trading: Procter & Gamble/Coty exchange offer
LGIM takes a hands-on approach to implementing passive strategies in its £330bn fund range through a process called ‘pragmatic replication’ which aims to exploit inefficiencies among the index where possible to maximise returns. This process is implemented by taking a collaborative approach to fund management. The global trading team works alongside 19 fund managers to devise and evolve trading strategies while additionally sharing in depth knowledge with each other where possible. Morning meetings as well as fund performance meetings are able to analyse not just market and index news, but serve as a place for in-depth investigations of tracking decisions that have previously been made.
At a glance: LGIM's index range
How LGIM implements 'pragmatic replication'
How does LGIM leverage index inefficiencies in reality? Case study: Procter & Gamble/Coty
The fund focuses on high risk-adjusted returns, combining macro and micro insights.
In September 2016, Procter & Gamble announced it was to split and combine its ‘P&G Beauty Brands’ business segment with Coty through an exchange offer. The multinational manufacturer of household and personal care product’s shareholders were offered the option of exchanging their shares for Coty. The option was on attractive terms and was offering up to a 7% discount, subject to an upper ratio limit of 3.9 (see chart right), and appealed to the managers of the LGIM portfolio. The exchange offer closed on 29 September with the ratio set at the upper limit of 3.9 shares of Coty for each share of Procter & Gamble. In real terms, this equated to a 4.3% premium to the three-day VWAP reference prices. The completion of the exchange offer in October 2016 saw an index weight reduction for Procter & Gamble. It did not impact Coty as the group is a non-index constituent. The LGIM portfolio participated in the voluntary corporate action, and decidedly exchanged Procter & Gamble shares for Coty shares which in the process captured a 4.3% discount. This meant that by selling the Coty shares and purchasing Procter & Gamble in the market, a profit of 0.26 bps was realised for the global portfolio.
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Head of Retail Propositions, Retail Index Funds, LGIM
Dan Attwood,
“At the same time, a growing number of investors are opting for factor-based investing. That offers them exposure to different investment styles while retaining many of the benefits of investing in index funds.” The affordability of index funds is one of its appeals. It’s unsurprising, then, that some clients look no further than the fees. Attwood suggests this is a mistake, counselling investors to delve more deeply. "For one thing, you need to be comfortable with the index that the fund is tracking,” he points out. “Is it giving you the exposure that you need in the portfolio?"
Since index funds were opened up to smaller investors in the 1990s, they have proved enduringly popular. Investors have embraced the ability to track the market at relatively low cost. The choices available have multiplied – but are investors acting judiciously in making their selections? And is there scope for this already wildly successful product to expand further? LGIM launched its first retail index fund over 25 years ago. Since then, Dan Attwood, the company’s Head of Retail Propositions, has witnessed a mushrooming of fund diversity. “You can now access pretty much any asset class through an index vehicle,” he observes. He continues to see new investors turning to index funds, whether as a sole vehicle or as part of a portfolio blended with active funds. And savvy investors are taking full advantage of the ability to build thematic funds in asset classes such as global infrastructure or real estate. “Getting exposure to markets in technology, healthcare or even lower carbon investments is increasingly popular,” Attwood says. The means of exposure is just as critical. Investors need to be aware whether their fund is investing directly in physical securities, or if it is using more complex and potentially risky methods. Foremost in this category are derivatives. In index funds these are mainly used in the form of swaps by synthetic Exchange Traded Products. It’s a low cost way to access asset classes that may be hard or impossible to track using physical assets, but it can add new complexity into the mix. Another common practice favoured by some index-tracking fund managers is stock lending – the lending of shares to a third party in exchange for a fee and some collateral. Like derivatives, this introduces extra counterparty and collateral risks into the investment process. Any investor needs to be sure that they are comfortable with those risks, Attwood contends. Investors must also be confident that their provider has the heft to manage index funds. “Scale is really important,” Attwood says. “Without scale, you can’t really generate the efficiencies and cost savings to manage low-cost index funds.“And with scale comes responsibility. Investors should be making sure that their provider works with the companies that they invest in, and promotes good corporate governance across environmental, social and general business issues. “That’s more than an emotional, nice-to-have advantage. We believe companies that manage their impact on society generally deliver better investment value over the long term.” Index fund investors have added regulatory weight on their side, thanks to the MiFID II regulations that are due to come into effect next year. And the reforms proposed by the FCA in its recent review of the asset management industry will bring further transparency and protection. None of this, however, removes the responsibility from investors to satisfy themselves about the behaviour of their chosen providers and funds. For Attwood, the regulatory changes are likely to fuel yet more growth in an already attractive product. “Investors like the fact that they get a diversified exposure, evolving in line with the underlying markets as indices rebalance and change over time,” he says. “And of course they are understandably keen on lower fees and transaction costs. Index funds are a global success story that will only go on and on.”
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Where next for the index fund phenomenon?
Colm has been Head of the EMEA region for LGIM’s Global Index Funds group since September 2016. Colm joined LGIM in 2012 to take on a new role as Head of Segregated Index, before expanding his remit in 2015 to be Head of International Index Development. Prior to joining LGIM, Colm was Head of Indexation at Irish Life Investment Managers. Colm has been a CFA charter holder since 2003.
Dan is Head of Retail Propositions at Legal & General Investment Management (LGIM). He is responsible for directing proposition strategy and acting as product specialist for LGIM’s retail index fund range. Dan joined LGIM in 2007, previously undertaking roles in both product management and product development.
Dan Attwood Head of Retail Propositions
Colm O’Brien Head of Index, EMEA
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