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What’s in an indice? (Demo)

Indices 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 indices did exactly that. Charles Dow, co-founder of Dow Jones & Co., first published an index of 11 stocks – nine of which were railroad companies – in 1884. The index was a measure of the stock price performance of the firms that formed the foundation of the US 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.

According to the Index Industry Association, there are now more than 3.7 million indices. This figure is often used as evidence that indexing has run amok. 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.

I don’t think it’s a stretch to say that index investing has been the most meaningful development in the history of indices. The advent of the first index portfolios in the 1970s turned market indices 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.

Indices adapt to global changes

This evolution from measure to target spurred further development. In the early days of indexing, it was tough for index portfolio managers. 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.

Indices adapted to accommodate. Making float adjustments to firms’ market capitalisation 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 minimising indexing’s effects on markets.

More recently, indices have moved into active management. This is evidenced by the growth of strategic or smart beta exchange-traded products. These products are underpinned by indices that try to codify market-beating strategies in an index format.

This latest phase in the evolution of indices 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 its flaws were laid bare. It was the meltdown that launched a thousand new ways to reweight indices. The common thread among all these new methods is that they stray from measuring the market and instead try to beat it.

The result is that index or indice is no longer a correct term and is in fact confusing. Perhaps as Ben Johnson of Morningstar laments; “true indices are those that most broadly measure a segment of the market. That implies full market-cap coverage and market-cap-weighting”.

Active strategies now occurring in index form

Given past history, it would seem Indices will keep growing and 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 minimising their impact on the securities they aim to track. Examples of this trend from recent years include Vanguard and iShares moving many of their index funds and exchange-traded funds to indices that capture more of the investable market.

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.

The evolution of indices has been a very good thing for investors. It has bought about continuing downward pressure on asset managers fees and what results they deliver.

Source: Original article published by Ben Johnson of Morningstar and reproduced by Future Gen Solutions