This article introduces and outlines the various indexing strategies along with their uses and importance for derivatives professionals.
Indexing Strategies: Definition
Indexing is – very simply – an investment strategy, which attempts to mimic the performance of a market index. An index is a “yardstick”, and a market index is a group or “basket” or portfolio of securities selected to represent and reflect the market as a whole. Indexing is, therefore, a passive strategy, because it does not involve either security selection or trading. The basket or portfolio of securities defined by the index is purchased, and held indefinitely.
Indexing Strategies: Popular Indexes
The most widely recognized index is the Dow Jones Industrial Average, which is composed of 30 large U.S. industrial companies. Despite its stature, the Dow is not particularly representative of the US market and most index funds tracking the US market are based on the Standard and Poor’s 500 (S&P 500).
In Canada, the most widely followed index is the S&P/TSZ Composite Index, which tracks the 1200-plus stocks on the Toronto Stock Exchange. Other indexes of interest to Canadian investors include the Financial Times 100, or “footsie” which is based on the London Exchange; the Nikkei, which is based on the Tokyo exchange; the Dax, which is based on the Frankfurt exchange, and the Hang Seng, which is based on the Hong Kong exchange. There are also a couple of important international stock indexes: the Morgan Stanley Capital International (MSCI) index and the Europe, Asia and Far East (EAFE) index.
Historically, the justification for index funds has derived much of its strength from the “efficient market hypothesis”, which maintains that the history of stock price movements contains no useful information that will enable an investor consistently to outperform a fully diversified randomly chosen portfolio. This view was supported by a number of US academic studies in the 1960s and 1970s and seemed to be confirmed by the experience of the 1980s, when US index funds significantly outperformed most actively managed funds.
The logical argument for index funds seems simple:
- the market is composed of either passive or active investors
- on average, the performance of passively managed portfolios matches the performance of the market
- on average, the performance of actively managed portfolios, must, therefore, match the performance of the market
- the net returns of actively managed portfolios will be lower than the net returns of passively managed portfolios due to the greater transaction costs associated with active management strategies.
The first two of these propositions are uncontroversial. There is also little doubt about the last proposition; the costs of managing an index fund are lower. There are several reasons for this. The most costly element of active portfolio management is security analysis, but index funds do not require security analysis, since the securities in their portfolios are determined by the composition of the index. In addition, the cost of buying and selling securities can be expensive in actively managed portfolios (depending on the degree to which the portfolio is traded). Since the composition of an index changes relatively little, index funds incur very minor transaction costs. Finally, most index funds are extremely efficient. In an actively managed fund, administrative inefficiencies may go undetected because they cannot be isolated from expenses, which are incurred in the pursuit of higher gross returns. In index funds, because gross returns are dictated by the returns of the market index on which the fund is based, cost inefficiencies in the operation of the fund have a direct negative impact on the fund’s net returns. As a result, competitive pressures usually operate to eliminate these inefficiencies.
The central claim in the justification for index funds is therefore the proposition that the performance of actively managed portfolios will – on average – match the performance of passively managed portfolios. The evidence typically advanced in support of this proposition is that the average fund actually underperforms the index in most years. In the US, for example, approximately three-quarters of all stock funds underperformed the S&P 500 index during the 1980s. But a more careful consideration of the data is more revealing. During the latter 1970s and continuing into the early 1980s, small capitalization stocks dramatically outperformed large capitalization stocks. By the 1980s, small cap stocks had become significantly overvalued. As a result, large-cap stocks began to outperform small-caps, and because the S&P 500 is composed disproportionately of large-caps, index funds appeared to outperform actively managed funds. The underperformance of actively managed funds stimulated a shift of assets to index funds, which were of course invested in the stocks of the index, driving the value of the index itself up in a kind of self-fulfilling cycle. It took the recession of 1990 to put an end to that cycle.
Evidence regarding the relative performance of active and passive funds is usually met with the argument that investors choose specific funds; they do not choose the “average” fund. While some funds underperform, others outperform the index. In response, advocates of indexing argue that even the funds which exceed the index in one or two (or even three) years cannot outperform on a sustained basis. Studies of mutual fund performance have consistently demonstrated that funds with the highest returns in any given period do not achieve the highest returns in a subsequent period. According to John Bogle, chairman of the US-based Vanguard group of funds, and one of the most forceful proponents for indexing, the top 20 stock funds in the US in any given one year period achieved an average rank of 284 in the subsequent one year period. Similarly, the top 20 funds over the decade from 1972 to 1982 ranked -on average – 142 (of 309 funds) in the decade from 1982 to 1992. The fact that periods of relatively strong investment performance are often followed by periods of relatively poor performance is called “mean reversion” and is regarded by advocates of indexing almost as an axiom.
There are however several problems with this argument. The first is that regression to the mean is far from self-evident. A careful look at the information used to substantiate this view reveals that the data is drawn from year-over-year returns. But focusing on discrete year-over-year performance puts excessive emphasis on short-term performance. Yet mutual fund investments in particular are long-term investments. Mutual fund investors do not typically invest on a year to year to basis. A more reasonable assessment of “mean reversion” would therefore focus on long-term compound returns.
In addition, it is well recognized that active portfolio management encompasses a number of different investment approaches and styles, and that each of these approaches and styles is more successful at some stages of the business cycle than at others. To properly judge the performance of active management, it is essential to evaluate returns over an entire cycle, and this means examining long-term compound returns.
Another problem with the arguments raised by those who advocate indexing is that there is a substantial difference between a portfolio manager’s inability to achieve top rankings in consecutive periods and an inability to outperform the index in consecutive periods. While Bogle’s analysis contends that the probability of sustaining top quartile performance is ‘only’ one in three, the important issue is the probability of sustaining performance, which exceeds that of the index. Not too surprisingly, Bogle does not offer data that illuminates this issue.
There is however a final argument for indexing. Drawing on modern portfolio theory, advocates of indexing argue that while actively managed portfolios may (occasionally) beat the index, they assume a disproportionate degree of risk to do so. On arisk-adjusted basis, indexing is the most efficient strategy.
To understand the concept of risk-adjusted returns, an analogy may be helpful. In baseball, a batter’s ability is measured not by the number of hits he gets, but by his batting average. If one player has 100 hits, while another has 50, we can’t say that the first is “better” than the second, because we also need to know how many opportunities each has had. If the first batter has had 400 “at bats” while the second has had only 150 “at bats”, then it is the second player who is better. The first batter has a relatively ordinary .250 batting average (that is, he hits once in every four “at bats”) while the second batter has an impressive .333 batting average (hitting once in every three “at bats.”) In short, meaningful comparisons can only be made on the basis of hits per “at bat.”
Modern portfolio theory applies the same principle to comparisons of investment returns. If portfolio “x” has an annual return of 18%, while portfolio “z” returns only 12%, we cannot immediately conclude that portfolio “x” is “better” than portfolio “z“. Instead of batting averages, what we want to know is the return per unit of risk. If portfolio “x” has twice as much risk as portfolio “z“, then our initial perception of portfolio “x” as the better investment is wrong: its superior return required a disproportionate level of risk.
There are at least two different techniques for measuring risk adjusted returns. The Treynor Index subtracts the risk-free return (typically the 90 day T-bill rate) from the return of the portfolio, and divides the remainder by the beta (b) of the portfolio. The Sharpe Index is similar to the Treynor Index, but the return in excess of the risk-free rate is divided by the standard deviation(s) of the portfolio rather than its beta.
The trouble with both these techniques for evaluating “risk-adjusted” returns is that they equate risk with short-term volatility. They are utterly meaningless in evaluating the relative merits of long-term investments.
Indexing and the Deficiencies of Active Fund Evaluation
Despite the shortcomings in the rationale for index funds, they continue to attract investors. The reason for this paradox is that the conventional approach to mutual fund analysis does not give investors any confidence that they can identify funds that will consistently outperform the market in the future. In his comprehensive analysis of mutual funds, Bogle tacitly acknowledges the possibility that it is possible to outperform the market when he observes that “…. some of these fund managers have done such a good job for such a long time that we can fairly assume they have unusual talents.” He then goes on to note that “…such extraordinary managers not only are few in number but are difficult to identify in advance.” This however is a far less powerful argument for indexing than the logical argument. In essence, it concedes that actively managed funds may beat the market, and argues instead that indexing is a kind of insurance against the risks of choosing a fund which may significantly underperform the market. Investors may not outperform the market with an index fund, but they will never underperform (by very much.)
The roots of the difficulty in identifying funds with superior potential are to be found in the excessive preoccupation of current analytical techniques with numerical comparisons. The information most commonly mentioned is compound returns, volatility (beta and standard deviation) and sector allocations.
Statistics such as alpha, R-squared and the Sharpe, Treynor and Jensen indexes (together with a variety of even more arcane measurements) are also regularly quoted. Conspicuous by its scarcity is data on the stability of management and the way in which investment decisions are made. Yet it is precisely these qualitative factors, which provide the best clues to the probability of superior long-term performance.
When investors choose a particular mutual fund, what they are really doing is choosing a manager for their money. And in evaluating money managers, it is sensible to examine not only their results but the approaches by which they were achieved. By relying on an index to define the portfolio, the fund manager has effectively delegated the stock picking function to some other person or agency, which has goals quite different from those of investors. The securities in an index are intended to reflect the liquidity, capitalization and volatility of the market, as well as its strength (or weakness) while the securities in an investment portfolio are intended to provide superior growth, or a stable income.
It is important to remember that the index is not entirely passive: it does change over time. although a great deal of care goes into the selection of the index, it nevertheless represents a specific view of the market. For example, in the effort to be representative, there is an inevitable tendency to include “newer’ industries in an index. These industries tend to be more actively traded and often have higher price-earnings ratios than more established industries. The consequence of modifying the index to include these industries is therefore to exaggerate increases in the value of the index, and distort the picture of the broader market.
Investors should be interested to know if outstanding performance was achieved by loading up on “hot” sectors, or was the result of superior selection of individual securities, regardless of sector. They should be interested to know if the fund’s decision-makers choose investments on the basis of consistent criteria, or whether they rely fundamentally on “gut feel.” Prudent investors would presumably want to know whether the manager’s organizational structure affected its investment decisions. Many funds for example hire portfolio managers on a contractual basis. There is considerable pressure on these managers to pursue high short-term returns in order to secure their employment, but the pursuit of high short-term returns can often jeopardize superior long-term returns. And they would want to know if the personnel responsible for strong performance is likely to remain with the fund into the future. Unfortunately, much of this information cannot be easily converted into numbers. As a consequence, its importance is minimized or ignored.
The Best of Both Worlds
Recently, a number of fund companies have developed so-called “super” index funds. These are funds, which purport to outperform the index by manipulating the relative proportion of securities in the index. While they are promoted as funds, which merely enhance the benefits of passive investing, the reality is that they are actively managed, since the manager must necessarily make decisions about which sectors or securities should be emphasized. As a result, they are more about exploiting the marketing appeal of indexing than they are about the merits of passive investing.
Indexing Strategies: A Final Note
At their root, index funds essentially abdicate the goal of outperforming the market in favor of (nearly) matching it. They are, like all “single decision systems” largely a mechanical substitute for thoughtful deliberation. Although it is true both that many actively managed funds underperform the market, and that the process of picking superior performers requires considerable skill, these two facts in no way lead to the conclusion that index funds are inherently better and that a strategy of indexing is the most prudent approach.