Perfection Impossible

April 01, 2002

None of us is as smart as all of us

- Anonymous quote hanging in the office of James Vertin, Head of Wells Fargo Management Sciences Department and backer of the first index fund. - circa 1971

I. Introduction

Indexes have advanced tremendously since the debut of Charles Henry Dow's pioneering average in the late nineteenth century. Indeed, particularly in the years since the launch of the first index fund in 1971, indexes and the art and science of indexation have risen to meet an ever-growing demand of uses, products and indexed assets. As the theme of this issue of The Journal of Indexes is "in pursuit of the perfect index," it is important to note that continual improvement in index methodology benefits investment managers and their clients alike, and will undoubtedly continue to do so in the years ahead.

Our industry should, of course, pursue better index methodology, but I believe we should not obsess over what inevitably would be a quixotic quest for one perfect index or index methodology. Investors use indexes for a diversity of purposes, and the needs of investors and the market evolve dynamically over time. Indexes must reflect this evolution and diversity. Competition among index providers and index managers will take care of the rest, ensuring that continual improvement occurs, and that investors have an optimal choice of indexes and index-based products.

The perfect index is in many ways "the impossible dream," but like Don Quixote, our pursuit of the ideal can make the world of indexes a much better place. This essay discusses the uses of indexes, and defines the characteristics of a good index as well as covering the critical tradeoffs in benchmark design. Finally we discuss how you go about choosing an index to suit your purposes. An index that is 'perfect' for one investor might be completely inappropriate for another investor. Thus when striving for perfection, one must continuously ask the question "perfect for what use?"

II. How Indexes Are Used - the Four Fundamental Uses

There are four fundamental uses of indexes, which I describe below. This article focuses on equity indexes, but most of the uses, the criteria for a good equity index and the tradeoffs necessary in equity index investment are similar for other asset classes.

Accurate Gauge of "The Market" and Investor Sentiment

Since their inception, market indexes have been widely used to answer the question, "What is happening in the world at this minute?" Condensing the prices of diverse securities in a market to a single statistic is useful because it reveals the net effect of all factors at work in a market. These include not only hopes and fears specific to companies in the index, but also broader factors - war, peace, economic expansion, recession, and so forth - that can potentially have an impact on share values. Thus a frequently updated stock-market index gives an indication of a country's economic outlook. Following the September 11th 2001 terrorist attacks in New York and Washington, for example, the relatively short duration of the market drop was a significant boost to the nation's confidence.

Asset allocation

As asset allocation has become accepted as central to sound investing, analysts have studied the historical returns and other characteristics of indexes in an attempt to understand the behavior of the asset classes they represent. An index constructed on a consistent basis across time allows one to calculate long-run rates of return, the risk of different asset classes, and the changes in risk of a given asset class over time. Indexes can also be compared to calculate correlations and gains from diversification across asset classes, and to perform other analysis relevant to developing an investment strategy.

Performance measurement

One of the attractions of having a market index available is that it answers the question, "Did I beat the market?" The natural human desire to best one's competitors motivates investors to compare their portfolio returns to index returns. The modern science of performance measurement, evaluation and attribution takes this obsession to the next level. It draws on the academic achievements of the 1960s - the capital-asset pricing model and related work - in determining to what extent, and why, a particular portfolio beat or was beaten by a market index.

Basis for Investment Vehicles

With the advent of the capital-asset pricing model, and other theories suggesting it is difficult to beat the market on a risk-adjusted basis, market-capitalization weighted indexes turned out to be well-suited for an important and revolutionary new use: index funds . By simply matching the holdings of a well-constructed index, a portfolio manager can provide the return of the index, net of expenses. Moreover, many active investors - particularly quantitative active, risk-controlled, and enhanced-index managers - use the contents of an index as their starting point, deviating from index weights according to the degree of conviction they have that a particular stock is more or less attractive than the market as a whole.

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