Indexing (updated 22 Feb 99)

Indexing is an investment practice that aims to match the returns of a specified market benchmark. An indexing manager or tracker attempts to replicate the target index by holding all - or, with very large indexes, a representative sample - of the securities in the index. Traditional active management is avoided with no investments made in individual stocks or industry sectors in an effort to beat the index. The indexing approach is often described as passive, emphasizing broad diversification, low trading activity and lower costs.

Indexing as an investment practice has won acceptability in the last two decades as the mechanical outgrowth of a body of academic insights about markets and managers. Indeed, it was one of the first ideas to be propounded by finance academics from their empirical studies. These pointed out that the average manager would produce sub-average results due to expenses - and above average managers would be identified and given more assets until they too became less than average. The system was the trap. After all, index accounts have prices set by all managers. In a sense, these accounts are the most managed of portfolios.

Indexing seems dull. Stock selection is done by a nameless committee at Standard & Poor's (S&P) or elsewhere for other indexes. Proportions are set by market prices, which are the aggregate wisdom of all participants. And administration is relatively simple because transactions are bunched together at the very instant at month end when the index composition may be rearranged.

In the late stages of the one-decision bull market of the 1960s, the idea of mechanically investing in the average just because it was the average would have failed. But in the mid-1970s when a sharp market correction slayed the old gods and raised up new ones, it was just the thing. Nothing could challenge a roster of active, aggressive managers better than to have a mechanical bunny running the performance race with them - and the bunny did not require dog food.

Indexing gurus

Early proponents of indexing were Wells Fargo, American National Bank and Batterymarch. Each had a slight variation that was designed to be superior; each had a booster or two from academia and each garnered a small percentage of some of the large pension funds in the United States. Curiously, endowment funds, run by successful alumni not faculty, were not among the early entrants.

Timing of the acceptance of indexing was critical. Following the nearly 50% US market decline in 1973-4, new ideas which might have been rejected just a few years earlier were sought. Ideas that challenged convention were readily accepted since conventional ideas had just demonstrated they could be costly in a decline. Each market phase brings forth its selection of new strategies to support hope and expectations. Indexing was right for the time and the time was right for indexing.

Wells Fargo endorsed investment in the full S&P 500 stock index with only a handful of de-selectees for prudence (reputedly, these handily outperformed even a risk-adjusted measure). American National had a sophisticated sampling technique to reduce transaction costs, a likely source of underperformance. And Batterymarch, thinking that index investors would ignore month to month wiggles of sampling error that would cancel in time, just bought the largest two hundred and fifty stocks, which were 90% of the total. Batterymarch also tried, and failed, to promote the notion that low cost mechanical replication of any index was the goal, not just the S&P.

Early clients were happy with the results, which kept pace with active managers even when small stocks pulled ahead in the new, quantitatively driven market just beginning. And more money came into the strategy in the billions. Meanwhile, the debates between passive managers, as the indexers were called in error (they were quite active promoters), and the active ones continued. Hardly an analyst meeting could be held without a debate on the program. Since there were few indexers and many active managers, the indexers' voices were strained. But they made their case with evangelistic fervor. More converts came to their side.

Investor meetings are always popular: they are usually held at attractive resorts, the topics are the most controversial, informal conversation often focuses on what to buy and sell - and they are often job markets. There are so many meetings that organizers have difficulty filling the speaker slots - so it is readily apparent how index could easily become the hot topic on the circuit.

Each of the major index firms did their time in the investment meeting wrestling arena. The most common format was a challenge debate between an indexer and an active manager. One set of debaters was the late Roger Murray, formerly of Columbia University and CREEF, matched with Dean LeBaron, one of the co-authors of this book. These two appeared together so many times that they would delight each other with a 'new' point. And once, in boredom with their repetitious roles, they reversed sides.

Murray's key point was that of course you could beat the averages and he had some former students who were doing just that. Besides, it was thwarting the capitalist system if everyone became a pricing parasite. LeBaron took an easily defended side - it seemed easy at the time - to do a little of both. And he had diversification charts, history, transaction prices, the lot. While to most people, indexing just did not seem right, why not try a little?

The indexers' cause was aided by negotiated brokerage transaction fees instead of fixed fees going into effect in May 1975. Since indexers were not paying for research with so-called soft dollars (to the investment manager, soft dollars are someone else's money and hard dollars are your own), they could drive down commissions immediately. And they did, often to 25% of the original levels. Later, commission rates for indexers would be zero and even less than zero when the indexer was providing merchandise for a broker to buy/sell at higher rates to other clients.

Eventually indexing, at the institutional level, became a performance tracking game. Monthly tracking with the index was the way in which managers' quality was established. Even if the index committees did something silly like add a moderately thinly traded stock at a single moment, indexing managers would have to add one too or face the even risk that waiting would prove 'active' and expensive - one must behave slavishly to track.

As many expenses would be put outside the funds as possible to keep the real outcome close to the theoretical one. And since all indexers large and small were acting in concert anyway, there was no advantage in large size. So the big managers got bigger.

Counterpoint

Indexing derives originally from the concept of market efficiency (see MARKET EFFICIENCY). But markets are only efficient if investors study all available information and move prices to reflect the published data. This implies that as the market share of indexers rises, institutions will employ fewer and fewer analysts, the market will become less efficient, and this will give active managers the chance to outperform the index and index managers.

Of course, there will always be actively managed funds that outpace index funds over long periods. But is it luck or skill? Probability indicates that some investment managers may provide exceptional returns over lengthy winning streaks. But there may also be some investment managers with truly outstanding abilities who can earn superior returns over time. The problem in selecting actively managed funds is how to identify in advance those that will be consistently superior over time.

On the surface, all stock index funds should have identical total returns. But they don't because their expenses vary. Expense ratios (the percentage of costs to assets) generally range from 0.2-0.6%. The average for actively managed funds is 1.3%. Since many index funds only began in the past few years, the high-cost ones usually justify themselves by saying there was a significant start-up expense. And some index managers admit privately that high expenses exist because the funds feel they can get away with it.

Another potential problem with indexing relates to corporate governance. As indexing took off, proxy voting slowly became an issue when the normal tool for expressing dissatisfaction with corporate behavior - liquidation of a stock position - was unavailable.

Part of the index fund advantage has resulted from being 100% invested in stocks at all times in a bull market - buying stocks going up and selling those going down because of companies going in and out of index. Indeed, this drives up the market as trackers are fully invested and do not allocate assets between equities, bonds and cash. Since most equity funds maintain cash reserves of 5-10% of net assets, they lost ground to index funds in the bull market in stocks during the 1980s and early 1990s.

Of course, in periods of market declines, index funds can be expected to have somewhat larger declines than funds maintaining cash reserves. Yet they may convey the illusion of 'safety'. Stock picking may work better in a flat or bear market - another justification for active managers.

Where next?

Today, indexing might be 20% of total US institutional equity. And now indexing is done on a number of indices like emerging markets, industry groups and other security classes. It is rather surprising that it is not greater. One feature that may have been restraining growth is the agency cover of indexing is not as great as with an active manager. More of the responsibility of investment selection may, under some interpretations, reside with the index client than with active managers. Furthermore, if equity markets have an extended decline, indexing may be arrested in its growth.

Indexing lends itself well to being packaged with other services like performance measures, custody and administration and corporate governance monitoring (see PERFORMANCE MEASUREMENT and CORPORATE GOVERNANCE). Thus, the management cost of indexing is often bundled with services customarily offered by large integrated banks.

Indexing is a strategy that has been applied to many different categories of investing. It provides an efficient way for investors to participate in broadly diversified portfolios. Nevertheless, many investors will continue to be attracted to the distinctive investment philosophies and strategies offered by the wide range of actively managed funds (see ACTIVE PORTFOLIO MANAGEMENT). A suitable compromise may be to build equity and bond portfolios (or even combine them through a balanced approach) with a core holding in an appropriate index fund. Around that core investment, an investor may select specific actively managed funds that appear likely, in the investor's judgment, to add incremental investment performance over the long run.

Read on

In print

Peter Bernstein, Capital Ideas: The Improbable Origins of Modern Wall Street - this book has more on the academic development and practitioner adoption of indexing

Online

www-sharpe.stanford.edu - the website of Nobel Laureate Bill Sharpe, a critic of active management
www.vanguard.com - website of the Vanguard Group, which has pioneered index funds for individual investors