How the increase in indexing is leading to the creation of more stock indexes, most of which are used by active managers. How more indexing makes it more difficult for active managers to outperform even though managers are getting more skilled.
In this episode you’ll learn:
- Why there are so many more stock indexes than stocks.
- Who are the major index players and how do they decide what to include in an index.
- Why it is important to understand how an index is constructed.
- Why more indexing is making it more difficult for active managers to outperform even though managers are getting more skilled.
While passive managers seek to replicate a particular market index, active managers endeavor to outperform indexes to generate excess return. With so many indexes to choose from, some may think that the popularity of passive management would provide greater opportunity for active managers to spot mispriced securities. In this episode, David Stein explains why this assumption may be flawed and why increasing active management skills may not mean greater return.
Why a large number of indexes helps managers
Currently, there are 3.3 million stock indexes…but there are only 43,000 public stocks. Why is this the case, and how do managers choose which to replicate? David explains that in order for managers to keep their jobs, the benchmark they use has to be representative of how they invest. Because it is becoming more difficult to outperform indexes, managers want several options available to them. Some managers show two or three indexes as benchmarks including those that are most representative of their investment style.
Another reason there are so many indexes is so financial firms can create new ETF products including strategies that previously had only been available to institutional investors. The increasing number of ETFs has led to increased competition and lower fees for investors.
S&P Dow Jones Indices, MSCI, and FTSE Russell are the top three players in the indexing business. While it is debated among some that politics and commercial needs influence the integrity of such large groups, there are several criteria that each follow when validating a new index. The index needs to be investable, able to be replicated in a passive strategy, and made up of stocks with sufficient liquidity. There are many opinions on which indexes include these criteria, and there is a need for a myriad of options among managers to choose from—both of which create an incredible amount of indexes to choose from in the end.
How index providers operate
Changes in indexes can be costly, which is why indexing groups must also consider whether a new index has sufficient maintenance methodology to provide a balance between index stability and timely mirroring of changes in opportunity. Generally, there is stability in the companies that comprise an index provider’s benchmarks. New opportunities come up, however, and new companies replace old ones. This index constituent turnover can lead to higher costs for index funds and ETFs due to the pricing impact related to index holding turnover.
Both ETFs and indexes are complex. Many managers create their own index for an ETF they want to create because it is cheaper than licensing someone else’s index. David explains that many managers use client assets and money to fund new ETFs. JP Morgan is an example of this, with 53% of JP Morgan clients owning the firm’s ETFs. Lower fees are one benefit of newer ETFs, and clients can benefit from firms using their money to build them. Full disclosure should be made to clients, however, before the firm utilizes client funds. To understand more about how index providers operate, listen to the entire episode!
Why an increase in active management skills isn’t creating greater alpha
David explains that one reason active management exists is because of traders who underperform the benchmark. These “noise traders” buy stocks for reasons and in patterns that deviate from fundamental analysis in terms of trying to identify mispriced securities. The inconsistencies created by noise traders provide more opportunity for active managers to spot mispricing in the indexes and generate excess return.
What has begun to happen, however, is that passive management has continued to rise in popularity, reducing the impact that noise traders have on security pricing. Even though active managers are growing smarter in their strategies, there simply isn’t enough disparity in security prices for active managers to take advantage of. Active managers are learning to take advantage of technology and education to hone their skills. But as more and more active managers become better, the more quickly mispricings are identified, reducing the actual impact that generating excess returns makes.
Knowing the foundation of an index
At the end of the day, market participants need to understand the underlying factors of the ETFs and indexes they are following or purchasing into. With so many available, it is important to know what facets are making up each index. How is the ETF constructed? What is the underlying index? What is the history of the index? How closely has the ETF been able to follow the index over an extended period of time? Each of these are questions to ask to help create a buffer against purchasing into just any index that comes up.
David reminds listeners that investing does take work. It requires research and time, but it is all doable. Anyone can be a successful investor if the basics are understood and followed along with hard work and some dedication. To learn more about indexes and passive vs. active management listen to the whole episode!
- [0:22] Definition of “alpha.”
- [0:49] Why there are so many indexes available.
- [4:35] The business of indexing.
- [7:01] The criteria that index providers use.
- [8:04] The cost of change in the index.
- [10:27] How some companies create ETFs.
- [12:44] Understanding the complexity of indexes and ETFs.
- [15:30] The influence of passive management on active management skills.
- [20:42] Understanding all the underlying facets of an index.
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