Mutual Funds

The lure of index investing

Craig Lazzara Fei Mei | Updated on March 16, 2013

What is an index?

Examples such as the S&P 500 and the Dow Jones Industrial Average easily come to mind. Members of media often rattle off the respective levels at timely intervals. They are useful tools in gauging economic conditions. But what is an index?

In simplest terms, an index is a portfolio designed to represent a market, broad or specific. The constituents change relatively infrequently. Changes, when they do take place, occur to maintain accurate representation of the market rather than to achieve investment performance.

Take the S&P 500 for example. Its popularity as an index of the US equity market is due, in part, to its longevity (since 1923) and its ability to always adapt to changes in the market. Apple and Microsoft, both among the ten largest index members, did not exist more than 40 years ago. Because it is market capitalisation-weighted, it captures the opportunity set available to all investors.

Seeking Alpha

In the investment world, attempting to validate the strategies of active management ultimately lends the strongest credence to passive investing. Alpha denotes performance in excess of the market. Relative performance, or more specifically outperformance (alpha), is the key measure of success in investment management. The margin by which a money manager beats the market (benchmark) is the proverbial measuring stick. Hal Arbit (1981) describes it best, “If the level of ability of enough market participants is ‘good,’ then being one of those good investors at the margin will not earn a client an excess return. Thus, if a professional investor is to earn excess returns for his client, being good is insufficient – he must be exceptional.”

The dilemma, however, is that neither theory nor evidence substantiate the suggestion that consistent outperformance is achievable.

In arithmetic terms, it is impossible for a majority of active investments to outperform the market. Because an index is a passive representation of the market – a reflection, if you will – and active investments contribute to that market. What’s more, this concept is not restricted to the investment market. It is how most of the world operates. If you think back to academic grades in school, the average performance is the level at which most students perform – simple math.

William F. Sharpe (1991) offers a simple mathematical explanation as to why this is. The market return is the sum of the weighted average of returns on the passive and active segments of the market. If the assumption is that returns on the passively managed dollar will equal the market return, then what remains, return on the actively managed dollar, must also mirror the market. Hence, the average passive manager will generate the same returns as the average active manager, before expenses. Alternatively, post expenses, the return on the actively managed dollar must be less than the passively managed dollar.

The pursuit of alpha invariably incurs costs. The same costs become a drag on returns.

Passive investing

In practice, SPIVA (Standard & Poor’s Indices Versus Active) statistics paint a far grimmer picture. Over a five-year period ended June 30, 2012, 65 per cent of large-cap equity funds underperformed the S&P 500. Moving down the asset class spectrum – where ostensibly inefficiencies and mispricing exist – the numbers look even worse for mid-and small-cap funds. Regardless of the time period observed or the asset class, most actively-managed funds underperform their passive counterpart.

This phenomenon probably has not gone unnoticed. In recent years, there has been a tremendous flow of assets poured into passive investment vehicles. This, in turn, has sparked a proliferation in the number of passive investment options in the marketplace. The investment world has long since moved beyond the S&P 500 in indexing capabilities. Specialized indices such as style (growth & value) and sector follow broad market indices and in the most recent past factor indices (also known as alternative beta indices) heralded another evolution in indexing. In recent years, arguments have been made that alternatively-weighted indices are inherently superior to their cap-weighted counterparts. But keep this in mind; capitalisation weighting is not an invention…the world is cap-weighted.

(The authors are Senior Director and Associate Director respectively, with the Index Investment Strategy, S&P Dow Jones Indices. )

Published on March 16, 2013

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