Are Best Practices Good Enough?

June 13, 2007

The more money that has flowed into indexed portfolios, the more of a science index investing has become. But is it enough? "Best practices" are certainly not a fixed target.

It is amazing just how much index methodology has changed in less than 10 years I've been around the business. It used to be easy pickings around index change time when indexed assets were still a blip on the radar. So it's a testament to the index industry, when the "real" super bowl of indexing (tm), which is Russell recon rolls around, that scarcely a scream of terror is heard in the indexing hallways.

And gaming indexes changes has become a crap shoot at best, because everyone trades around them, announcements are staggered, etc. So even though trillions of dollars are moving around index flows cumulatively, it's harder than ever to make a quick buck at an index investor's expense.

A lot of the innovation has focused on a few key things. Probably primary amount them is keeping turnover down. That's what bands are all about. Next in line is mimimizing market impact. Of course, with less turnover you're trading fewer stocks you can make an impact on. But also, liquidity screens lessen the impact of a squeeze on the buy side, and preannouncements make it tougher to be frontrun.

Come to think of it, why am I wasting my breath going through best practices. All you need to read really is Gus Sauter's seminal "Index Rex" article. It continues to be the best piece I've ever read outlining the true characteristics of a good investable index. And Gus has ideas in there that were never implemented - like staggaring changes over the year in monthly tranches of 1/12 of the in or out. GREAT idea. TOUGH to make happen for a number of reasons having to do with existing index users not named "Vanguard"

And all this is the reason I'm dying to have Gus do an update, or, say a quantititive defense of cap weighting. Because the proof is in the pudding. This guy know's index funds. And he's a Browns fan. So he knows the virtues of patience...which is what good index investing is all about.





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