Indexing Sheds Passive Clothing

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 21^st 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.

State Of The Index Investing Union

So I reached out to Rick Redding, CEO of the Index Industry Association, an industry group that pays attention to this kind of thing.

ETF.com: What do you see as the definition of an index today? Is it the same as it was 20 years ago?

Rick Redding: An index is still an index.

ETF.com: Is index investing a different animal than it was 20 years ago?

Redding: It’s gotten a lot more difficult to define what that means. A lot of it has to do with the growth of the ETF industry. By definition, to have an ETF, you have to have an underlying index. We've kind of gone from a world where it was pretty much a market-cap weighting, or you would have something like the Dow, but it was pretty simple what an index fund was.

Now, almost anything that's put into an ETF, by definition, has to have an index created for it. Active and passive doesn't make that much sense anymore. It's become rules-based investing versus active investing.

Rules-based is just more transparent. That's why I'm using the term “rules-based,” because in order for it to be out there, it has to establish rules that are transparent for people to see, whereas in the active days, you or I could claim to be a value manager, and “value” is kind of what we perceive value to be.

ETF.com: What are some of the pitfalls with factors, academically proven or not, as the index engine?

Redding: Companies are getting harder to put in categories. For example, take GE leaving the Dow and the recent GICS sector change around communications. When you think of the communication sector, you think AT&T and Verizon, but that's not all that's in the box anymore. How do you classify some of these more digital companies that touch on so many areas? They have content, technology.

It’s becoming a lot more difficult to put them in these boxes that we've had historically. Thinking long term, looking at it in a different way and classifying companies a different way will ultimately lead to a whole bunch of different types of indexes and investable products in the long run.

My Conclusion

Who in the industry hasn’t been at an ETF conferences where “education” is stressed over and over, but then the industry turns around and keeps morphing old definitions—indexing—into new animals, or creating new terms like “smart beta,” as opposed to the dumb old thing you have?

Redding’s definition of “rules-based,” as opposed to the sheep’s clothing of “passive,” should be high on the education agendas at ETF conferences. From there, you can dive into the passive or active examination.

Retail investors are not easily fooled. They’ve learned from the financial crisis that owning the market is OK; beating it is hard. The learning curve for them is that indexing can be both.

Drew Voros is Editor-in-Chief of ETF.com; he can be reached at [email protected]