Perfection Impossible

April 01, 2002

V. Would Proposed Indexation "Solutions" Actually Distort the Core Role of Benchmark Indexes?

As would befit a dynamic and innovative industry, there are a variety of proposed "solutions" to the shortcomings of indexes that have been introduced in past year or so. The problems they attempt to address generally focus on the transaction costs and market impact of index changes, and thus the solutions are rooted in the belief that a change in approach would reduce that impact/cost as well as providing other benefits. The "solutions" that have been put forward can be grouped in three broad categories:

  - Introduction of funds based on "silent" or proprietary indexes.
- Switch to peer-based/average manager holdings-based benchmark
- Adaptation of a "pure passive" approach to index portfolio management

Response to The Concept of the "Silent Index"

Gary Gastineau of Nuveen Investments proposes limiting index transparency to minimize index effect. The basic tenet of efficient markets is transparent information flow and equal access to information source. Confidentiality of trading plans and opaqueness in index methodology creates inequity in information flows and increases uncertainty. Uncertainty raises risk and volatility, and higher risk and volatility increase trading costs and market impact, bringing us back around to the issue we wanted to eliminate. Recent research by Simon Hookway of Westbury Asset Management has in fact demonstrated that pre-announced constituent changes have a substantially lower "index effect" , For exchange-traded funds, which Gastineau is specifically addressing, transparency is not only an important feature of the ETF product, but also an integral part of the ETF mechanism. It lowers the cost to the investor because it enables precise hedging by market makers, who are willing to take on market-risk with a known, hedgeable portfolio of stocks.

I am fundamentally opposed to the 'Self-Indexing Fund' idea because it becomes all too convenient to hide active risk behind the mask of a "Silent Index". Gastineau alludes to the outperformance a Silent Index can offer, yet recent research by both Merrill Lynch and Goldman Sachs concludes that the S&P 500 index effects are diminishing, even as (or perhaps because) speculative capital targeting of major index changes has surged. I would argue that any divergent return is the result of active risk, and that the alpha could be either positive or negative. This ex-ante outperformance promise rings similar to the vibrant claims we heard in late-2000/early 2001, when the sell-side and competing index providers claimed that Provisional EAFE would defintitely outperform EAFE by 'at least' 100-200 bp, when in fact it underperformed in the first phase (May 31 2001 through November 30 2001) by 6 basis points. In fact, BGI calculated that when incidental country and sector bets (which provided a 35 bp gain) are stripped out, the net stock add/delete impact (i.e the pure "index effect") was a negative 41 bps.

Finally, the problem this solution attempts to address has not only diminished significantly as mentioned above, but is generally confined to the most popular indexes such as the S&P 500 and the Russell 2000. Many investors are actually moving to broader index strategies. These indexes are not affected by the sort of turnover that prompts the buying and selling that causes the index effect.

Peer-Based or Average Manager Indexes

The peer-based index proposes to use the determination of active mutual fund managers as a way of efficiently determining what asset classes are, and what benchmark and investable indexes should contain. This logic would deem that the appropriate benchmark should simply measure what active managers are holding in their portfolios, i.e. a variant of peer universes. While appealing in a zen-like way (it is what it is) this kind approach would risk mimicking active managers' tendency toward herd mentality, and insufficiently capture the true universe of the asset class.

The problem with this strategy is that ostensibly, the objective of both the theory and practice of index investing is to accurately reflect the investable opportunity set. Active managers tend to drift toward the latest fashion, and do not stay put in their pre-defined asset classes. Another practical problem is related to the challenge of "pre-defining" a size or style benchmark based on what managers actually hold, when the disclosure of these holdings at best has a significant time delay, and at worst, is opaque. As noted in above, transparency is vital for an efficient benchmark, yet peer-based benchmarks are by definition, ex-post. The alternative to this approach, of course, is a the true meritocracy of manager competition against an accurate investable-universe index.  

Total Market Benchmarks/Allocation and "Pure Passive" Portfolio Management Approaches

As an overall Investment Strategy, the concept of bypassing combinations of sub-asset class benchmarks (e.g. S&P 500 and Russell 2000) and replacing them with broad market indexes is quite sound, and this trend is strongly underway for both U.S. equity and internationalequity investment. The Russell 3000, Wilshire 5000, S&P 1500, DJTM, and MSCI ACWI ex-US and FTSE All-World have all made significant strides in attracting attention and assets recently. The low turnover, low costs, and high tax- efficiency associated with these indexes, together with their broad diversification, make them appealing for many investors.

The extension of broad market theory to index porfolio management has evolved so that certain index fund managers are promoting a "pure passive" style of indexation, essentially offering a "relaxed" approach to index changes, to the end of lowering turnover, potentially minimizing the "index effect" and ideally maximizing portfolio wealth. This concept makes good sense in theory, but it is still far from clear that investors will accept significantly higher tracking error (especially negative tracking) when they retain "brand name" indexes as their policy benchmarks. This potential outcome is similar to one of my concerns about Silent Indexes and the funds that may be based on them. Namely, in addition to potential cost/performance benefit from trading away from major index changes, higher tracking error will inevitably result from unintended (and therefore uncompensated) size/sector/style bets.This could result in underperformance well beyond the potential savings from avoiding specific index change events. Ultimately, as stated at the outset of this essay, competition between both benchmark methodologies and approaches to indexation is healthy, and I'm fully confident that the marketplace will decide the merits of the various products.

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