Indexing Sheds Passive Clothing

June 29, 2018

Index investing compared to active investing used to be easy to explain to anyone.

Back in the day of its infancy and adolescence—late 1970s, ’80s, ’90s—index investing could be easily defined as an investment offering exposure to an established index like the S&P 500 or any other broad-based equity index, Dow Jones, Russell 2000, etc.

As indexing was growing up, the lore of Wall Street’s genius stock picks were top of the tongue: “If you had the right broker, you could do well,” the myth went. If you argued that the same could be said for an index fund, there would be no golf invitations for you.

“Active investing” then and now is hands-on, driven by the hot stock picker striking or striking out and perceived market insiders with the magic “alpha” element that proves unreliable over time. Add to that 2% a year of “costs” before the first whiff of green, or red for that matter.

However, index investing has morphed into something far and beyond the John Bogle idea of a buy-and-hold group of market-weighted stocks that would earn market returns, which historically are darn good here in the U.S. The trigger for change, though, was the financial crisis, the lightning bolt that Zeus nailed investors with.

Along Came Smart-Beta ETFs

Fast-forward to the 21st century. Traumatized investors from the financial crisis then began missing the market-low bus in 2009, They couldn't trust the idea of buying stocks after being burned, no matter who or what landed them in the active fire.

That's when indexing started morphing into a different beast. There had been some dabbling in things like equal-weighted, fundamental and factor-based indexes before that, but suddenly “smart-beta ETFs” started creeping up and attracting the attention of investors who saw it as something new.

The idea that you could wrap the academically proven financial factors, a la Fama-French, such as value that active managers had been using in their “stock picking,” into an ETF seemed like a solution to active’s failure and improvement over boring market returns in the passive wrapper.

However, it was more that active management had invaded passive investing, via the Trojan horse of “smart beta” indices, posing as something safer than a cigar-smoking stock picker looking for momentum stocks.

But the changing face of indexing was just beginning to accelerate beyond the active recipe, into all kinds of weird stuff.

Indexes For Everything

Today we have an “index” for everything, from obesity indices and millennial indices to social media sentiment indices and even religious-belief-based indices.

The clash between the use of proven academic factors versus the unconstrained factor zoo has made all of this harder for retail investors who may be lured by the accolades heaped on passive indexing they are responding to 10 years late. But they may be really buying, at best, a passive-aggressive approach to the ideals of basic index investing.

Rick Ferri, CFA, a veteran financial advisor and thought leader when it comes to index investing, summed it up recently on Twitter during a discussion about what indexing has become.

“An ‘index’ is now any list of securities weighted in any manner maintained in any way and created by anyone,” he tweeted, implying an index hardly means passive investing.

He was responding to Cullen Roche, another asset manager and longtime voice on FinTwit, who opined the word “passive” has lost all meaning and should be dropped from our vocabulary.

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