It is possible to create indexes that are meaningful benchmarks for managers who follow growth or value investment styles, focus on large- or small-cap stocks, or look for some combination of those characteristics. The starting point is this cardinal rule: An index must reflect the way that money managers actually invest.
This may sound like circular reasoning-defining value as what people call value. The reality, however, is that growth and value, and small-cap and large-cap, are what investment managers deem them to be. Modern portfolio theory doesn't define any of those terms. Managers do. The indexes that track these sectors should incorporate the thought processes of these managers. The best index isn't necessarily the one that provides the highest return; it's the one that most accurately measures the performance of the style it's designed to track.
This article proposes guidelines for the construction of ideal indexes. With better tools, investors will be able to make better decisions about how their money is managed. Some indexes already incorporate some of these proposals, but no index incorporates all the guidelines.
These guidelines are not intended to make the lives of index fund managers easier. An index fund is a rational investment only if it provides an alternative to active management in a low-cost, relatively tax-efficient way, or if it offers exposure to a segment of the market in which active management is difficult, if not impossible. For instance, micro-cap stocks are too illiquid to be managed actively in a portfolio with high turnover. Indexes designed only to simplify the lives of indexers probably wouldn't meet these criteria. However, if the rules for creating indexes based on the behavior of active managers also simplify the indexers' job, so much the better!
I. Rely on Objective, Not Subjective, Rules
An index can be rules-based and objectively maintained, with no ambiguity about when a stock should be included or excluded. Alternatively, an index can be more subjectively reconstituted by an individual or committee according to broad guidelines. Each approach has pros and cons.
A purely objective approach ensures absolute style integrity and total transparency, precluding debate about the merits of including one stock or another. However, it also can, but does not have to, result in short bursts of high turnover, raising costs and tax inefficiency. Active managers, even those with high portfolio turnover, don't implement six months' or a year's volume of portfolio adjustments on a single day.
On the other hand, a subjective approach to index maintenance may allow for more orderly management of changes. This approach, however, is subject to committee decisions that do not represent the decision process of active management.
The most important characteristic of indexes tracking the market's subsectors—in essence, sectors created and defined by managers—should be that they accurately reflect the thought processes of active management. For that reason, style integrity is extremely important, and an objective set of rules for creating an index is preferable to the vagaries introduced by a subjective process.