This article is an excerpt from Steven Schoenfeld's forthcoming book, Active Index Investing, which is scheduled to be published by John Wiley and Sons in July, 2004.
Active index investingis not an oxymoron. However, the term passive investing, which is commonly used to refer to indexing, is truly an oxymoron in the investment management industry. No investment activity is passive and, as many chapters in my forthcoming book demonstrate, managing an index fund is a complex and highly active endeavor.
Another popular misconception is that "indexing guarantees mediocrity." The reality is far from it; in fact, aside from the well-documented long-term track record of indexing in outperforming traditional active managers, the use of index products within an actively managed approach can often achieve better results than an active approach that doesn't utilize index products.
But what exactly is active indexing? The term has multiple meanings-enough, in fact, to name a book on the concept.
As an adjective, active can describe the way in which the art and science of indexing is "anything but passive." In the form of a noun, active indexing can be defined as an investment approach that uses index vehicles and techniques to implement active strategies. It is not always about producing alpha-it could be about maximizing the efficiency of an asset allocation decision or involve a strategy to reduce country or sector risk. But it is definitely not "plain vanilla" indexing, nor is it passive.1
With the availability of index funds and ETFs on virtually any index and subindex (not to mention the wide array of index futures and options), a range of strategies that were previously designed for institutional investors can now be implemented by almost any type of investor. Index products' three primary advantages-low cost, transparency and precision of return-allow investors to create active strategies without major slippage in implementation. In addition, these same three advantages make performance attribution of the strategy a relatively straightforward exercise.
Active indexing strategies deliver specific value by the following three methods:
- Actively allocating between sector, size, style or country/ regional index portfolios;
- Using index products to plug "risk holes" in an investment strategy or overall strategic asset allocation;
- Actively customizing the portfolio within an index benchmark framework.
These alternative indexing and weighting approaches can deliver value in several ways. In this article I will discuss the first two methods in detail, while the third approach is discussed in several chapters in my forthcoming book.2 I emphasize emerging market equity strategies in this article, partly because I have significant experience in this area but also because these volatile markets are surprisingly appropriate for active index strategies.
I hope this article serves to broaden the Journal of Indexes readers' understanding of how investors can be "as active as they want to be" with index-based strategies. The examples and case studies are not designed to be comprehensive, but rather to illustrate the virtually infinite flexibility of the potential applications across the ever-expanding range of index products and techniques.
Asset Allocation And The Efficiency Of Index-Based Active Strategies
Many studies have shown that the most important decision a pension plan sponsor makes is the policy allocation decision.3 This also applies to the individual investor, for whom asset allocation should be the core of the investment strategy. Just as the pension plan sponsor must carefully determine the overall allocation strategy, an individual investor should focus on choosing an investment 'policy' instead of spending excessive time on stock research.4
Investment returns are driven more by the asset allocation decision than by the funds or stocks chosen within the asset classes. The oft-cited 1986 article by Brinson, Hood and Beebower proved that 94% of the variability of performance was attributable to the investment policy. Although this number has been challenged, a more recent study by Surz, Stevens and Wimer concluded that the policy decision explains actual returns experienced even more closely than previously believed. In their 1999 article, they found that the investment policy accounted for 104% of the total return for mutual funds (and 99% of the pension funds in the study).5 This means that outside the benchmark decision, actions such as timing, stock selection, and fees detracted from the performance.
These studies demonstrate that it is crucial to make the appropriate policy/strategic allocation decision first and foremost. The selection of stocks and/or actively-managed funds within the asset class has generally detracted from total return. Therefore, investors should expend more attention and energy on determining an investment strategy and less time on choosing managers (or being active themselves within the strategy). In fact, the cited evidence strongly suggests that after determining the investment strategy, investors would improve results by simply choosing index products that track the asset classes within the strategy.
Sophisticated institutional investors have long recognized this. They focus their energies where they believe they can add value, and where they don't have the skill or resources they take an index-based approach. Getting efficient exposure is the most important factor in their success.