The modern history of index investing is roughly three decades old and divides into three epochs: the 1980s, when index futures, options and derivatives arose; the 1990s, when the tech boom powered the discovery of index outperformance; and the 2000s, when ETFs put indexes in everyone's portfolio. Each of these was big—big enough to last a decade and change the investing landscape. Now the Journal of Indexes is challenging us to consider the issues that will likely concern index investors in the near future. The last few years of housing crisis, financial crisis and now the European debt crisis should remind everyone that forecasting is difficult, and forecasting the future is even more difficult. The usual disclaimers—no one knows the future; and what follows is based on opinions, not facts—apply.
The theme for the next epoch of index investing is competition: competition for ideas on index construction; competition between complexity and simplicity; competition between ETFs and mutual funds; and competition to eke out gains in a slow-growth economy. These differ from the themes of the last 30 years. Index futures and options in the 1980s were new ideas and new instruments, opening up new opportunities for investors. Index outperformance existed since the first index fund but went unrecognized until the late 1990s. ETFs, though created in the early 1990s, were largely unappreciated until the turn of the century. All were new ideas or newly recognized ideas. Their newness led to their success. This time around, the next big thing will need to battle competitors for success.
For a long time, indexes were either price weighted or cap weighted; at the same time, many investors didn't think about weighting at all or they erroneously assumed indexes were equal weighted. Those days are over, and various approaches to index weighting are battling for investor attention with performance claims. For the moment, the combatants seem to fall into a few groups: traditionalists (capitalization, price and equal weighting); other size measures (financial measurements like revenues or earnings or combinations of financial measures); and attributes or factors (measures of stock attributes like value, growth, dividend yield or momentum). Since one key gauge of success is performance, and performance depends on ever-changing market conditions, it is impossible to predict a clear winner. If we could match a weighting scheme to the market it works best in, we would have a big thing: a way to know what to do and when. Most likely, that kind of weighting choice will elude investors, and the battle among weighting schemes will turn in part on the next competitive contest.
Simplicity Vs. Complexity
Almost all the new indexes of the last few years have one thing in common: Compared to the S&P 500 and the Dow Jones industrial average, the new indexes are complicated. Consider one of last year's big things, the S&P 500 Low Volatility Index. As indexes go, this one is reasonably straightforward: Start with the S&P 500, take the 100-least-volatile stocks and weight them by the reciprocal of their volatility. At the same time, the index is three steps removed from the S&P 500, an index familiar to everyone. Complexity gets more serious when we consider leveraged, inverse, weights that change depending on market events and performance, multiple asset classes, hedging currencies and other factors. The challenge is to add something to gain a performance edge or reduce risk without becoming so confusing that no one knows what the index might do or why.
If this challenge seems far-fetched, recall some of the confusion when leveraged and inverse indexes with daily resets appeared a few years ago and how a number of larger brokerage firms restricted sales of these products to sophisticated investors only. One can make a strong case for simplicity, and most likely few of the complex approaches will survive, and even fewer would qualify to be a big thing. Simplicity vs. complexity will certainly be part of the next contest.