Providers are continuing to innovate, changing the nature of indexing, Ben Johnson, CFA, writes in the latest blog on bonds and indexes.
In February, Robert J. Jackson Jr., a member of the U.S. Securities and Exchange Commission, and Steven Davidoff Solomon, a law professor at the University of California, Berkeley, published an op-ed in The New York Times with the title, “What’s Really in Your Index Fund?” They wrote:
“But [here] is the problem: The indexes…may not be as neutral as they seem. The firms that devise these indexes face little regulatory scrutiny and can face significant conflicts of interest, which have the potential to harm American investors.”
The authors raised these conflict-of-interest fears as a response to a Wall Street Journal report that index provider MSCI relented to Chinese government pressure to add Chinese companies to the MSCI Emerging Markets Index. MSCI denied the implication.
The writers also cited the Libor scandal as further evidence of index manipulation, even though Libor was the concoction of a cabal and had nothing in common with more traditional market benchmarks.
But buried under the authors’ intriguing title, misguided Libor comparisons, and general fear-mongering are some important questions about the role and influence of index providers, how they have evolved over time, how they will continue to evolve in the future, and whether or not the manner in which they are regulated should also change to reflect this evolution.
Here, I take a closer look at the metamorphosis of index providers that’s transpired over the past century-plus.
Measuring sticks
Indexes are meant to be measuring sticks.
They give us a sense of where markets have been and where they stand today. The original stock market indexes did exactly that. Charles Dow, cofounder of Dow Jones & Co., first published an index of 11 stocks—nine of which were railroad companies—in his Customer’s Afternoon Letter on July 3, 1884. The index was a measure of the stock price performance of the firms that formed the foundation of the U.S. economy at that time.
Fast forward nearly 135 years and a lot has changed. Dow’s first index was a flop. His next was a hit. The Dow Jones Industrial Average, launched in 1896, still occupies prime real estate on the masthead of The Wall Street Journal (the successor to Dow’sCustomer’s Afternoon Letter) and is piped through a variety of media that would be unrecognizable to its creator. The index industrial complex that his original idea spawned might be jarring to Mr. Dow.
According to the Index Industry Association, there are now more than 3.7 million indexes. This figure leaves many breathless and is often used as evidence that indexing has run amok. But indexes are to their constituents as the 10 million colors Meare made of. Both are a product of the selection and combination of a finite list of ingredients.
Far more meaningful is how we’ve arrived at that 3.7 million number. The 100-plus years it took to get from a single index to nearly 4 million have been marked by significant evolution in the realm of indexing. Here, I’ll look at how indexes have evolved and share my thoughts on how they will continue to change and what it means for investors.
From measures to targets
I don’t think it’s a stretch to say that index investing has been the most meaningful development in the history of indexes. The advent of the first index portfolios in the 1970s turned market indexes into targets. Most notable among them was Vanguard founder Jack Bogle’s creation: the first index mutual fund.
What had started as a means of taking the market’s temperature evolved into a yardstick for active managers and ultimately the bull’s-eye for an emerging crop of index portfolio managers.
This evolution from measure to target spurred further development. In the early days of indexing, it was tough for index portfolio managers to hit their bogies.
Funds were subscale and expensive, trading was costly, handling corporate actions like mergers and acquisitions was tricky, and rebalancing attracted the attention of opportunistic traders looking to front-run index events and push stock prices higher ahead of index inclusion.
Indexes adapted to accommodate.
Making float adjustments to firms’ market capitalization to better reflect the investable market and reduce trading costs was once controversial. It is now an industry standard. Changes to communicating and executing index events like rebalancing, additions, and deletions have also been driven by the growth in index-tracking portfolios and the demands of their sponsors.
All these incremental changes have been aimed at reducing the cost of indexing for investors and minimizing indexing’s effects on markets.
From targets to a new form of active management
More recently, indexes have mutated into a form of what they’ve long been used to judge: active management. This is evidenced by the growth of strategic-beta exchange-traded products, or ETPs.
These products are underpinned by indexes that try to codify market-beating strategies in an index format. As of Dec. 31, there were 694 such ETPs in the United States with combined assets under management of $704 billion—representing over one fifth of all ETP assets.
This latest phase in the evolution of indexes was driven in large part by asset managers’ desire to offer something different from standard market-cap-weighted index exposure. The case for moving away from market-cap-weighting gathered steam in the wake of the bursting of the dot-com bubble, when cap-weighting’s flaws were laid bare.
"Indexes are meant to be measuring sticks."
It was the meltdown that launched a thousand new ways to reweight indexes. Pioneers of these approaches included the likes of PowerShares (which was subsequently acquired by Invesco IVZ) and WisdomTree Investments WETF. The common thread among all these new methods is that they stray from measuring the market and instead try to beat it.
So, what is an index?
The metamorphosis from measure to target to active management has sucked the meaning out of the term index. I would argue that “true” indexes are those that most broadly measure a segment of the market. That implies full market-cap coverage and market-cap-weighting. Anything different begins to inch across the passive-to-active spectrum in the direction of active management.
From here to where?
Indexes have long stopped being stagnant, neutral benchmarks, and they will keep evolving.
The purest of them will continue to be refined with an eye toward capturing a fuller spectrum of the world’s financial markets and minimizing their impact on the securities they aim to track. MSCI adding China A-shares to its Emerging Markets Index is one example.
Other examples of this trend from recent years include Vanguard and iShares moving many of their index funds and exchange-traded funds to indexes that capture more of the investable market and CRSP moving to a five-day rebalancing period for its U.S. stock indexes to mitigate market impact.
I expect asset managers and index providers will keep trying to distill active strategies into an index format. To the extent that strategic-beta ETFs are less costly, more tax-efficient, and rigidly rules-based, they might have a leg up over more-traditional approaches to active management.
But the arithmetic of active management still applies. The average fund will match the market before fees and lag it once fees have been accounted for. The evidence we have thus far shows that this new brand of active management will likely yield similar results to more-conventional forms.
Indexing will inevitably expand to new frontiers. There are corners of the market that will become more accessible over time. As this happens, investor interest will grow and along with it the demand for indexes to measure these market segments and obtain exposure to them via index funds. Real estate investment trusts are an example of an area of the market that went from fringe to mainstream in this manner.
Investors win
Investors have benefited tremendously from the growth and evolution of indexes. Their use in performance management keeps active managers honest. Their use as the basis of index funds and ETFs has reduced the cost of investing and given investors an alternative to active management.
"Indexes have long stopped being stagnant, neutral benchmarks, and they will keep evolving."
Their more recent transformation has further tightened the screws on active managers, delivering a new form of active management at a competitive price point. Indexes have been a disruptive force, and I expect that they will continue to tilt the landscape in investors’ favor.