Talking ETFs With Northern Trust's Steven Schoenfeld

Jan.10.08 | About: iShares MSCI (EFA) assistant editor Heather Bell spoke with Steven Schoenfeld in December about asset allocation and other topics. Schoenfeld is the chief investment officer for Global Quantitative Management at Northern Trust Global Investments.

Index Universe: What do you think is happening with the real estate market, and what is it telling us about the U.S. economy as a whole right now?

Schoenfeld: The numbers don't lie. There is a range of indicators—whether it's data from the real estate industry or the S&P/Case-Schiller indexes or other indexes and indicators—that clearly points to a continuing downturn in residential real estate. We've not seen sustained weakness in commercial real estate, although the exuberance is no longer there.

The big question is a combination of declining residential real estate values and the more restrictive environment for credit: Is that going to tilt the American consumer further into a cautious stance and hurt the economy that way? Because consumer spending is, depending on how you measure it, between 60 and 70 percent of the U.S. economy. You can't deny what's happening in real estate. How will it affect the consumer and will that negative impact—because there is nothing very positive about that—be offset by the benefits of continued economic growth and exports due to the weak dollar? Greater economic minds than mine are still not sure, but I think the balance of probabilities is that we're going to have a weaker economy. Will it tip into it a recession? As of December 2007, I don't know.

Index Universe: What trends have you noticed in the field of indexing?

Schoenfeld: I'd say there's three powerful trends in the broad indexing field that are independent of each other, so they're powerful in their own right, but then there's cross-synergies that make them even stronger. The first is the embracing of indexing for a broader group of asset classes, in the acceptance of indexing as one of the most efficient ways to get beta. And the trend toward taking that beyond U.S. equities where it's long been accepted—international equities, new asset classes such as global real estate or global infrastructure, and subasset classes such as international small-cap and emerging markets. I consider it powerful general acceptance of indexing for efficient beta among a broad range of investors.

The second follows neatly on that: continued, very strong, secular growth in the use of indexing for the broadening and deepening of portfolios, in particular for international equities. By "secular," I mean not dependent on market cycles. The best example of "broader/deeper' is the trend of going "beyond EAFE" (i.e., developed international large/mid-cap). That includes emerging markets, that includes international small cap and increasingly it will include emerging markets small-cap, and even the nascent or frontier markets. You've seen the growth of new benchmarks for those areas. It's the same situation going deeper into fixed income, so you're seeing more and more slices of fixed income becoming available, and I believe this will extend into international fixed income.

The third trend is the use of indexing to combine asset classes—or put another way, using these "building blocks of beta" to create multi-asset strategies, whether it is target date or other types of allocation where you have conservative, moderate or aggressive-type allocations. This is something that I discussed extensively in Chapters 30 and 31 of Active Index Investing, but at the time of publication [2004], it was highly aspirational. Now it's happening! These multi-asset-class capabilities will be dramatically expanding the use of indexing in the coming years.

I would say those are the three most powerful trends, but there, of course, are many others.

Index Universe: Is the interest in areas like international size and style approaches actually returns-chasing or is it a legitimate interest in simply expanding into an area that was not previously explored?

Schoenfeld: I'd like to believe that it's all about rationalization and harmonization of investors' benchmarks and allocations for international as they increase their investments in international. That's what the theoretical purist and the idealist within me would like to believe. That being said, I don't think investors would be increasing their allocations to international as strongly and as enthusiastically as they're doing if you didn't have good performance over the past few years. People wouldn't feel as much of an imperative.

On one hand, because these markets have added performance in the last few years, there's more interest in it. If we had three years of underperformance, it actually might be even a better time to invest in those areas, but you wouldn't have as much excitement. A case could be made for both the chicken and the egg of why investors are putting more into international, but the fact is that institutional investors, retail investors and financial advisors are putting higher and higher allocations in non-U.S. That is, to me, an unambiguously good thing, and it's been something that I've been urging probably for over 10 years. [Read Steven Schoenfeld's article on the subject, "Recapturing That International Flair," in the November/December 2005 issue of the Journal of Indexes here.]

It's so important that investors shed the home country bias that has characterized U.S. portfolios for so long. It sounds like a cliché, but it remains true—we live in a globalized world and non-U.S. blue chip companies are as active in the U.S. economy as U.S. blue chips. As that bias is being reduced, the anomaly of having just a large-/mid-cap developed market benchmark such as EAFE as the primary benchmark for international investing becomes that much more obvious. And that is why I've said publicly, and I'll say again, that EAFE is obsolete. What makes EAFE obsolete?

Schoenfeld: It's not that EAFE itself is a bad index. In fact, with the new MSCI methodology improvements, it's become a better index. But the fundamental problem is that EAFE doesn't cover the whole international opportunity set, just like the S&P 500 doesn't cover the whole U.S. equity opportunity set, and thus, as investors put more money abroad, they need to take their international strategy to a broader and deeper benchmark, such as a broader and deeper MSCI index, which would include emerging markets, Canada and small caps; namely the new MSCI Global Investable Market Index ex-US. The same "total international" solution could be constructed with the FTSE All-World ex-US, the S&P/Citi BMI ex-US, the Russell Global ex-US or the broadest and deepest of them all—the Dow Jones Wilshire Global Total Market Index ex-US, which includes 57 countries and 98% of market capitalization. We've been doing a lot of work for the past three years around this concept at Northern Trust, and we've developed our Total International Equity Strategy solutions for both institutional and individual clients—we think the time is right for investors to finally align their portfolios with the opportunity set.

The idea is actually quite simple: Investors should take a Russell 3000 or Wilshire 5000 approach to non-U.S. investing, and to do otherwise means you're either restricting your index exposure to too narrow a slice of the pie, or worse, benchmarking your active manager with the wrong index. Active managers are already heavily invested in international small-cap and emerging markets, but if you keep EAFE as their benchmark, you're giving them a free ride to go outside the benchmark, and you're not properly measuring the investment universe.

Index Universe: What part in this do frontier markets play? They used to be pretty marginal, but they have been getting so much more attention now.

Schoenfeld: They're getting more attention, and I think that's a great thing. Here at Northern Trust, we're in the middle of our own research and development on a frontier market product, and we're talking with clients about it and we've been getting a positive response. But it's still a very small part of the overall investment universe.

If and when more investors vote with their feet and start investing in frontier markets, we will happily include them in their overall international equity strategies. But before investors include that in their portfolios (and consultants include it policy benchmarks), they need to include emerging markets small-cap stocks, which is a capability that we're already able to offer our index-based clients. So I do believe we'll see commitments to frontier markets, but it's going to take some time. Of course, I would be thrilled beyond belief if we get to the point where most investors have broadened and deepened their benchmarks to include emerging, to include Canada, to include developed international small-cap, emerging market small-cap, so that everyone's got these complete seamless benchmarks and then people are saying, "What about frontier markets?" Because that will mean we would have had an enormous amount of progress in achieving the "broader/deeper" and therefore complete and seamless international equity exposure that we've been encouraging for so long.

Index Universe: Do you believe investors should just use one benchmark that encompasses all of these subcategories proportionally?

Schoenfeld: The answer to that is "it depends." If it is a large institution, the most important thing is that their overall policy benchmark—the benchmark that measures their exposure to the international equity asset class—be a broader, deeper and complete benchmark, as discussed earlier. This is often a joint decision between the plan sponsor, its board and their primary consultant. And after using this measure of the complete non-US investment opportunity set, just as they do for U.S. equities currently, then they can hand out mandates to a mix of index and active managers that help them gain complete, seamless exposure. So if their overall benchmark is the MSCI or FTSE benchmark that covers this whole universe, then they can give out specific developed and emerging markets and international small-cap mandates, and where they can't find active managers, they can use an index fund to fill in the slice. But their overall perspective is that they're covering the complete investment universe.

For retail investors as well as financial advisors, an interesting way to approach this would be to continue using the active managers that you're comfortable with (and have confidence in their ability to produce risk-adjusted outperformance, and be very aware of what their benchmark is), but also be sure that you have complete exposure to the whole international space by using index funds for these subcomponents, or one could consider a foundation of total international equity exposure via an index fund or ETF that covers the entire asset class. At Northern Trust we call this a total international equity strategy, or TIES.

[Read a related article by Steven Schoenfeld and Stefanie Jaron, "International Equities," in the January/February 2008 issue of Journal of Indexes here.]

Index Universe: Where do you stand in the debate over fundamental indexes?

Schoenfeld: We [Northern Trust] published a white paper in May 2006 on the subject, and the main point that we make in that paper is caveat emptor, or "buyer beware." [You can find the article here.]

Investors need to know what they're buying; they need to understand what "baked-in" tilts—which are inherently active tilts—are in these various fundamental indexes. We don't think they're necessarily "bad" investment strategies, but we feel they are most decidedly not index strategies. They are a kind of static, quantitative active tilt, embedded into an index construction methodology, and I often refer to them as "quasi-active." If you fully understand what they are and you're willing to commit some of your money to them, you just have to really know in which type of environment they work well. For example, many of the currently popular fundamental index strategies have a distinct value and small-cap tilt, so an investor moving into these strategies needs to believe that either/both value and small will outperform in 2008.

In addition, one of the key points we continue to make with clients is, if you are considering these kinds of strategies, which have a tilt baked into them, why not also consider what we call traditional enhanced indexing, which is a quant model that continues to evolve its approach and is explicitly trying to beat the standard index (and often the manager only gets significant fees if he or she actually beats the index)?

[Read an article on alternatively weighted indexing that Steven Schoenfeld and Robert Ginis wrote for the Journal of Indexes here.]

We urge investors to take a caveat emptor, full disclosure, know-what-you're-buying-and-consider-all-the-alternatives approach to this. Some may want to claim that fundamental indexing or alternatively weighted indexing is something new, or something that is unique and proprietary and even something that should be able to be patented and/or trademarked. But in our paper we demonstrate how alternatively weighted indexes have existed for a very long time and it's not something that's new—and in fact goes back several decades. As an example, in the [July/August 2007 issue of] Journal of Indexes you had a profile of Henry Fernandez, where he reminded people that the GDP-weighted EAFE was the first fundamentally weighted index, way back in the mid/late 1980s. So we want to remind people to get beyond the hype and look carefully at what's really there.

Index Universe: Do you think that the period of value outperformance is drawing to a close?

Schoenfeld: Well, it's drawing to a close until it starts again. I'm not being flip, because it definitely had its time to shine. But as noted previously, I think we clearly have seen this year [2007] that growth has trumped value, and value will eventually come back, whether in 2008 or perhaps more likely in 2009. The question is, how much will these indexes that tilt toward value underperform between now and when growth comes back?

Index Universe: Do you think enhanced indexing works?

Schoenfeld: I do believe—strongly—in the long-term potential for enhanced indexing. I think enhanced indexing, like all active strategies, goes through periods where the market environment is good for it and bad for it.

2007 was a challenging year for most enhanced and quant active strategies because there were many quantitatively oriented hedge funds and leveraged players who had many of the same overweight positions as long-only quant managers. When the subprime and credit crunch hit in the summer—particularly August, although the impact has continued—they needed to raise capital and they raised cash where they knew they had a liquid market, which was equities. So you saw a very sudden and sharp unwinding of position that continued to reverberate into September, October, even into November. Long-only or minimally leveraged players such as all the enhanced indexers—not just ourselves, but all the major firms—were caught in that disruption, and these strategies were challenged.

I believe that there is an important role for enhanced indexing in investors' portfolios. As with the false dichotomy of "active vs. index," there shouldn't be an "either/or" debate about the role of enhanced indexing—it's a highly efficient form of risk-controlled active management that over time delivers a high information ratio. The right way for investors to allocate their portfolio is to, first of all, diversify across asset classes, and we know that indexing is one of the best ways to get exposure to an asset class. Then, if they have the time and the inclination to take the active risk of using active managers—enhanced or quant active, traditional active managers, or alternatively weighted indexes, which as discussed is another type of active tilt—they should do the research on these approaches and the different managers of such approaches.

If they like what the process delivers historically, they should then diversify across those styles and have a mix of index, enhanced index, quant active, traditional active, and alternatively weighted indexes. And therefore they will be diversified across asset class and across styles and techniques, and the net result should be that all of these strategies will work as a kind of counterbalance for each other. So when you hit a period where enhanced or quant active underperforms, hopefully some of your fundamental active managers will outperform. But ultimately, at the end of the day, cap-weighted indexing will always deliver the beta of the market in a cost-effective and transparent manner. That's the enduring logic of indexing and it holds up in all types of market environments, and increasingly, for almost every asset class.

Index Universe: Do you see the role of index-based investment or index-based strategies increasing in the field of retirement as individuals become more and more responsible for their own future retirement?

Schoenfeld: Without a doubt, and it's both happening and accelerating. Indexing provides efficient delivery of beta, and that is important because the ultimate determinant of performance as many, many studies have proven, is asset allocation. So getting the beta right is so much more important than choosing the right manager, that's point one. Point two is that cost matters. As Jack Bogle says, while much of the investment theory for indexing has been based on the efficient markets hypothesis [EMH], the reality is that for most investors, especially smaller investors, the "cost matters hypothesis," or CMH, is more important. And indexing is so much more efficient from a cost perspective that it is going to have to be a part of any retirement program.

Index Universe: What place do you see commodities having in this? Like frontier markets, they're currently getting a lot more attention. Do they have a place in the average investor's portfolio?

Schoenfeld: I believe they do. Furthermore, the financial industry, just in the last three or four years, has developed a range of superb vehicles to give individual investors commodity exposures in an efficient way, both direct commodity exposure, and exposure to commodity-related equities. The bottom line is that individuals can now get exposure relatively cheaply, and commodities can play a diversifying role in almost all investors' portfolios. At Northern Trust, our Investment Policy Committee has a recommended strategic allocation to commodities for most types of clients. I don't believe that commodity exposure should or will rival that of equities and fixed income. However, I think it provides very important diversification, and there are a lot of trends under way that will mean that it's not going to be any easier to pick which commodities are going to add the value. But if you look at commodities overall and you look at world economic growth (especially in emerging economies) as well as demographics, it should be an important part of a portfolio. Commodities used to be something that was hard for investors to access, and now it's much easier.