All-powerful index transforms investing

By John Authers, Financial Times | September 09, 2015

After some summer turmoil, the FT is concluding a long series on indices, and how they have risen far beyond their original place as handy benchmarks to become important drivers of world markets. It is time to summarise the conclusions.

First, and unavoidably, they have come to lead markets on occasion, and not just to follow them. That is because of the rise of passive index-tracking strategies, which dominate inflows — particularly in the US. The practice of benchmarking is also responsible — active managers know that their career depends on how their performance will compare to their index, and so the index has come to dominate their thinking. Changes to their benchmark virtually force them to make changes to their portfolio.

At this point, the example of Chinese A-shares understandably dominates the conversation. To the surprise of many, MSCI decided to defer including A-shares in their much-followed emerging markets index at the beginning of the summer. This would have sparked more flows into China. The decision appears to have been one of the catalysts for the dramatic sell-off that followed. But there are many other examples.

Second, there is the argument that indices contribute to bubbles. When they are weighted according to market capitalisation, funds tracking them will be obliged to devote more of their new inflows of cash to stocks that are rising. In this way, indices tend to be pro-cyclical and drive more money towards overvalued stocks. This is bubble-forming behaviour.

This is even more of an issue in fixed income, where indexes are traditionally weighted according to total debt issued. This means that more indexes take on a great weighting in borrowers as they become more indebted.

Third, indices are more different from each other than you think, and those differences are not sufficiently understood. The Dow Jones Industrial Average and the Nikkei 225 are weighted by share price, rather than by the market value of their companies, often leading to random distortions; Germany's Dax index unlike almost all others includes dividends; the Russell 2000 smaller companies index makes no requirement that its members should ever have turned a profit, unlike some rivals; the committee selecting members of the S&P 500, the most tracked index of all, has far wider discretion than many realise.

Fourth, the sheer profusion of indices means that it is hard to use any one index to stand for "the market" — and ironically the closest approach to such a thing, the US Total market index compiled by the Chicago-based Center for Research into Security Prices, is only rarely cited in the mainstream media or in sell-side research.

S&P Dow Jones produces more than a million indices on its own, while many of its competitors have several hundred thousand. Indices capture many different facets and segments of the market. They are tools to help asset allocators place bets cheaply and efficiently. That cheapness makes index investing hard to beat — but it is no longer the "passive" investment in "the market" that many retail investors think it to be.

Fifth, index providers are leading a charge to weight indices in new ways, under the rubric universally called "smart beta". This brings them into new and contentious territory. Indices are avowedly attempting to pick stocks. This narrows the gap with active management.

On the positive side, smart beta should diminish the tendency of index investing to inflate bubbles. Smart beta does not accept valuations as they are, but deliberately bets against them. This is healthy.

Against this, smart beta could call into question the critical advantage of index investing — cost.

Several smart beta styles such as momentum, require heavy trading. Their historic back-tested returns may look great on paper, but can they really be achieved in the real world, without erasing all their gains through trading fees? And will smart beta providers slap on active-style front-end fees? Many seem to be attempting to do so.

Finally, there is one unambiguously positive point. The profusion of indices enables an understanding of the workings of markets and the drivers of investment performance that was unimaginable even 10 years ago. This potentially levels the playing field between large research departments and self-directed individual investors.

Indices have given everyone much better tools with which to invest. The key is to understand them and to use them safely.

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