The Best Of Both Worlds

May 01, 2006

PhotoIndexing's history is one of amazing growth. From humble beginnings, indexing has grown into a major force in modern finance. Its story has been well documented, as has the philosophical and academic thinking behind its growth.[1] As long as market participants wish to segment their investable universe, this growth will continue, and could progress to the point where indexes outnumber assets, if they don't already. Some of the new indexes populating the finance world borrow strategies from active management in a cross-pollination that is good for both the market and the investor. We aim to show how active investors might learn from indexing, particularly through the implementation of a new business model that separates the development of an investment strategy from its execution. The result is an "Active Index" that promises to deliver active strategies to investors at lower costs and with better transparency.

In contrast to indexes and passive management, active management has received very bad press in recent times. There are a number of valid reasons for this. Successful active managers are hard to find. Even if an investor can find a manager who outperforms for a full year, the probability that the manager will repeat that performance a second year running is between 50 percent and 62 percent.[2] It is a mathematical certainty that the average manager[3] will underperform the market by his fees.[4]

Unsurprisingly, much of the growth in indexes has come at the expense of active managers. Ever more innovation by index providers has been accompanied by increased understanding of indexes by the financial community. Recently, this has led to the introduction of non-cap-weighted indexes, ranging from advanced style indexes to dividend- or fundamental-weighted indexes, and even a resurgence of equal-weighted indexes. The growth in this new field is illustrative of indexing as a whole.

Unfortunately, this growth has been accompanied by an equivalent growth in confusion over exactly what these new products are and how they best can be used. Any investor trying to make sense of this situation would be forgiven for their confusion; after all, there is considerable disagreement between the providers of the new indexes themselves.

Part of the reason is that the finance industry is encumbered with a large amount of jargon. Even words like "active" and "passive," for example, have different meanings to different investors in different situations. As we try to make sense of a new product area, this can inhibit our understanding. In discussions with clients, the definition of terms takes up as much time as anything else.

Seeing Through The Jargon

Finance literature is full of attempts to help investors understand financial products. Schoenfeld draws a distinction between index investing and passive investing, saying that index investing focuses on replicating index returns, while passive investing focuses on reducing costs and risks while using an index as reference.[5] Bogle defines an index fund as "a fund designed to return investors 100% of the returns delivered by the stock market, less a nominal charge for expenses…"[6]

These types of definitions shape not only the market's thinking, but also the market itself. As we consider the new field of non-cap-weighted indexing, it is necessary to be doubly precise, hence the need to clarify and separate the concepts of "active" and "passive." It may seem misleading to some to draw a line in the sand between these terms, given that there are clearly many shades of grey in between. But it is necessary to be precise in our definitions if we are to further our understanding of new indexes.

The term "active" denotes energetic activity. To be "passive" is to accept or submit to something without objection or resistance, or to give no response to an action. Within finance, the best broad-brush definition of a passive approach is replication. A manager who replicates an index, for example, has no desire to improve on that index. His job is to passively accept the index return as it is, and match or replicate it to the best of his abilities. For this reason, we call the replication of an index return "passive management." The term "active" can be applied to a fund manager whose sole aim is to outperform an index, either with higher returns or with the same returns at lower risk. We therefore define an active strategy as one that seeks to improve upon its benchmark's return.

One area of confusion about the definitions of "active" and "passive" is style. The segmentation of the market into value and growth, a response to the cyclical outperformance of one segment over another, has prompted index providers to publish style indexes. The approach of selecting stocks using these styles, however, was originally an active strategy, and the use of these indexes can still be considered active. For example, a manager could use a value index to actively tilt her exposure to the Fama-French value risk factor.[7] That said, the indexes themselves are passive because they replicate the value or growth segment of the market.

It is also necessary to state the obvious and separate the role of an index provider from that of a fund manager. Fortunately, this is fairly straightforward. An index provider publishes an index. A fund manager implements a portfolio. Typically, an index provider is passive, because his indexes replicate a market.[8] The resulting association of passivity to index-providing inhibits our understanding of non-cap-weighted indexes; perhaps some of them should not be classified as passive. Figure 1 clearly separates these terms.

Figure 1

Figure 1

What Can Active Managers Learn From Passive Managers?

The definitions of "active" and "passive" are difficult to pin down, but highlighting the differences between the business models is much more straightforward.

In response to client demands, the indexing business model separates the functions of index construction (the investment strategy) from index implementation and trading. This business model requires partnerships, with one company defining, calculating and publishing the index, and another company holding the stock portfolio and implementing the trades.

This contrasts with active management, where a single company both creates and implements the strategy. There are elements of any active manager's investment strategy which must take into account trading decisions, creating a beneficial overlap of skills between traders and strategists. Despite this, could it be advantageous, in some circumstances, to divide the functions of strategy creation and implementation? Is there a role for an Active Index?

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