Talking Indexes

September 01, 2006

David BlitzerToday, almost every index is called "investable," although little thought is given as to what that actually requires or how to achieve it. At the same time, investability is increasingly important to the way indexes are used for investments and investment products. Liquidity and low tracking errors don't just happen, after all: They must be part of the index design.

The "investability" of indexes has not always been an issue. When Charles Dow launched the Dow Jones Industrial Average in 1896, no one wondered if he or she could invest with an index-the indexes were designed to measure the performance of the market. The same was true some 30 years later when the Standard Statistics Company-a predecessor to Standard and Poor's-introduced the first capitalization-weighted indexes. The belief then was that capitalization weighting was a better way to measure the market, not that it would transform indexes into investment products. Indexes were used strictly to study or gauge market performance, to support attempts to predict the market and to see how well investors did at picking stocks. It would take several decades and a lot of economic and financial theory before the idea of investing in indexes caught on.

While financial theory made progress in the 1940s and 1950s, indexes didn't move much beyond newspapers and stock charting services until the 1960s, when the first serious attempts to see if investors could beat the market were made. Michael Jensen's 1968 article, The Performance of Mutual Funds in the Period 1945-1964, both established alpha as the thing to measure and found that mutual funds didn't offer much of it.1

Harry Markowitz moved things along with the advent of Modern Portfolio Theory, which outlined the benefits of diversification and laid in place the foundation of the Capital Assets Pricing Model (CAPM) and the trade-off between risk and reward. As tests and debates about Markowitz's work spread, what we now call benchmarking became established. Indexes were used to understand overall market movements, to relate the market to the economy and to evaluate investment managers.

In the 1970s, a new idea appeared: investing with an index. By the end of the 1970s, there were a number of institutional investors doing just that-more often than not tracking the S&P 500 Index. It was around this time that the first (and still the largest) index fund for individual investors, the Vanguard 500 Index Fund, came on the scene. Indexing had moved from the analysts' calculators and the technicians' charts to the trading room. The significance of this move was confirmed at the beginning of the 1980s with the introduction of index futures and options.

New uses placed new demands on the indexes then available. In the early 1980s, there were relatively few indexes compared to today, and most were associated with one or another stock exchange. In the U.S., the leaders were the aforementioned Dow Jones Industrial Average and S&P 500 indexes, while globally, there was the MSCI EAFE Index.

In the benchmark days, an index had to generate performance numbers that didn't contradict what investors were experiencing in the market. A good index might also provide some related statistics like P/E ratios that some felt could warn of the next market pullback. But once funds, futures and options appeared, a new requirement was the ability to buy all, or at least almost all, of the stocks in an index in the correct proportions and with reasonable speed and costs. Otherwise, investors would discover they weren't holding, or hedging, the index-just some vague look-alike portfolio.

In the early days of investability, the S&P 500 was in the right place at the right time. First, it was (and is) a capitalization-weighted index, so rebalancing was only necessary when stocks were added to or deleted from the index, or when there were share issuances or buybacks. Second, the index rules required that each stock have a public float of at least 50 percent, so illiquid, closely held stocks were excluded from the get-go. Third, because the index tracked leading companies in leading industries, it tended to focus on large, well-established companies, which were generally easier to trade in large quantities than their smaller peers. All this made the index liquid and investable, which was especially important in the 1970s and 1980s, when trading was much more costly than it is today. (It was especially important before 1975, when commissions were fixed.)

As indexes evolved with the introduction of futures and options, and then with ETFs about ten years later, the number of indexes expanded rapidly and indexes began to specialize into two classes: benchmarks and investable/tradable indexes.

Benchmarks aimed to be comprehensive and complete. To achieve this while including closely held stocks, float adjustment was introduced with the Salomon Brothers World Equity Indexes, now the S&P/Citigroup Global Equity Indexes, in 1989. Less than two decades later, almost every index-including the MSCI EAFE and S&P 500-were using float adjustments.

At the same time, the demands of investability meant that tradable or investable indexes could not be compr hensive or complete. There were some stocks that wer too closely held, too highly priced or too hard to trade to include in an investable index.

Until all stocks are truly liquid and easy to trade, or until trading systems can move a 10,000-share block of Berkshire Hathaway A shares as easily as a round lot of Microsoft, we will face a split between investable and benchmark indexes. The concerns are far greater outside the United States. Most of China's equity markets, for instance, are in A-s h a res, which are available only to domestic Chinese investors and institutions; meanwhile, most of the world's investors (those outside of China) must be satisfied with B-shares and/or Hong Kong and Nasdaq-listed companies. Similar conditions apply to India and Russia. (These are three of the four "BRIC" countries one hears so much about. The S&P BRIC 40 index is tradable-but only because it includes stocks listed in New York, London or Hong Kong, rather than any of the BRIC home markets.)

The hunt for investability has recently expanded as indexes take on a new role-that of opening formerly unin-vestable markets. In May 2006, S&P introduced the S&P/Case-Shiller Metro Area Home Price Indices. This is a series of 11 indexes covering 10 major metropolitan regions and a national composite. The indexes use a repeat sales technique to measure home prices across the United States. The Chicago Mercantile Exchange trades futures based on these indexes. Owner-occupied housing is a major asset class, slightly larger than equities in the U.S, and it is also an asset class that has historically been inaccessible to institutional investors: They can buy rental properties like apartment buildings, but these are not the same as single family homes. Thanks to the new indexes and their related futures, residential housing is now an investable asset class.

The hint to investors is to look carefully at the indexes they use-benchmark indexes make for poor investment vehicles and some tradable indexes don't tell the full story about the market they track. The need to distinguish between benchmark and investable indexes is not a fault of index construction; it is a result of market conditions and investor needs. The results of using the wrong index for the wrong purpose can be seen in high expense ratios for some ETFs, large tracking errors for funds and basis risk in futures.

Endnotes

1) Jensen, Michael, "The Performance of Mutual Funds in the Period 1945-64," 1968, Journal of Finance.

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