Indexing has gained prominence in Canada in recent years. While it has been a solid part of U.S. pension fund portfolios for the past two decades, it is only in the last three or four years that it has come into its own in Canada. In the last year, for example, indexed pension fund assets in Canada have increased by more than 50 per cent, twice the industry average growth rate of approximately 25 per cent.

The use of indexing has increased for pension funds which manage their assets in-house as well as those which outsource investment management. Indexing itself involves managing a portfolio in a controlled manner so that its performance matches that of a particular index such as the TSE 300. Its growth can be seen in a variety of contexts: small and large pension funds, defined benefit and defined contribution pension plans, balanced and specialty mandates, and a wide range of asset classes. It has also received considerable publicity in the popular press.

Why has indexing found a foothold in Canada and what will the role of indexing be in the future?

The arguments presented in favor of indexing and related styles are straightforward: strict risk control, broad diversification, long-term median or better returns, and low cost. In recent years, plan sponsors have responded to these benefits as they have re-examined the structure and policies of their pension funds. As well, disappointment with the volatile performance of some managers has led them to review their style choices. Neither performance nor fees alone are the issue. The primary focus is value.

Sponsors have become more aware of risk as well as return. There is new interest in risk control, monitoring and attribution. Often, the conclusion is that active managers should be paid only for their risk-adjusted value added. This has led to the establishment of a core portfolio, using indexing, with one of several, clearly defined, active styles as a complement to the core.

Education and awareness have played a large role in the growth of indexing. As more sponsors have turned to indexing in a variety of ways, they are sharing their experience with colleagues. There is always comfort in knowing that others have paved the way. As well, indexing now has a solid track record in Canada with many years of live history to show that it is as viable in practice as it is in theory.

In recent years, everyone has become more sensitive to issues of style, control and process. Sponsors and consultants want to know that managers have a well-defined, consistent style based upon a reliable process. Those managers who can articulate their style clearly and who stick to it have fared well.

Indexing has great appeal to pension plans as a disciplined style. It is largely process-driven. It is not dependent on "individual" performers but rather on teamwork and technology. Sponsors know what they are getting and there are no surprises.

As well, costs are always on the minds of plan sponsors. Fees for indexing are a fraction of those for active management. And it is not simply bottom-line fees, it is also the value received for the fees paid. When the majority of active managers have difficulty outperforming the index, as has been the case for Canadian bonds, sponsors seriously question the value they receive for the fees they pay. In some cases, active managers have acknowledged this challenge and lowered their fees.

Performance, of course, is the key issue for any pension fund. Depending on the asset class, indices have been near-median performers for longer time periods, although they have deviated from the median over shorter time periods.

More importantly, it is the combined performance of the various managers that is key. Pension funds, must ultimately, meet their liabilities as efficiently as possible and it is the combination of assets and styles that determines if these goals are met. Thus, many large pension funds find themselves virtually compelled to use indexing for a core portion of their portfolios because a large stable of active managers with varying investment styles may very well produce indexed returns in aggregate anyway. This is why manager structure is so important and why indexing finds its way into plan structures so often and in so many different ways.

These observations do not apply just to defined benefit plans. Defined contribution plans also offer core, low cost investment options to their participants. Index funds have the attraction of providing broad market returns and plan participants will not be faced with below-market returns after fees. Plan sponsors are keenly aware of their fiduciary responsibilities as well as the potential liabilities that could be faced if their defined contribution plans underperform the markets. For the participants, indexing is easy to understand and can be monitored everyday in the newspaper.

What can we expect for indexing in the coming year and beyond? Pension fund restructuring is an ongoing process and we expect indexing to gain more "shelf space." Demand from defined contribution plan sponsors and participants will also grow as participants become more sophisticated and knowledgeable.

For most plan sponsors, it will not be an active versus passive decision. Rather, sponsors will continue to seek the appropriate combination of complementary styles that will help them reach their goals.

There are several things that could dampen the prospects for continued growth in indexing. Some fear that in the next bear market a fully-invested strategy, such as indexing, will underperform active managers who often have cash allocations in their portfolios. While this could affect short-term decisions of some pension funds, most look at the longer term realizing that timing the active/passive decision successfully is as difficult as any market-timing strategy.

For those plans looking purely for performance, there will always be active managers with very strong performance. The issue becomes can the sponsor pick them in advance and will the manager consistently outperform. If the indices severely underperform the majority of active managers for an extended length of time, indexing will have less appeal.

In the future, active managers may continue to counter the low cost appeal of indexing by lowering their fees. Other active managers may, instead, identify the complementary natures of their styles and indexing, creating potential for enhance returns while controlling risk (and cost) at the total-portfolio level.

Indexing in Canada is a viable and acceptable alternative. As it grows, variations on the pure indexing strategies, such as enhanced indexing, will be developed and incorporated into fund structures.

Happily, sponsors do not need to choose between active and passive styles. Both are appropriate and are usually complementary. Indexing is now one of the many tools used in building sound, cost-effective, risk-controlled portfolios.

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