Indexology^® Blog

Yesterday’s Wall Street Journal offered a profile of fixed income investors who aim to “break [the] chains” by which they are supposedly confined by index benchmarks.

As the bond market falters, investors are seeking shelter in funds that aren’t tied to indexes.  These bonds funds are known as “unconstrained,” “go-anywhere,” “absolute return” or “flexible” funds, and they are gaining in popularity on both sides of the Atlantic…

This echoes a theme we also hear in the equity markets — that managers need to be “more aggressive” (typically by holding fewer stocks) in order to improve their performance.

Improving performance is not quite as easy as the article implies.  Moreover, investors, both institutional and individual, compare managers to indices for a very good reason.  The reason is that absent some objective standard, the fund owner has no way to judge whether the asset manager’s performance was good, bad, or indifferent.  Admittedly, “some objective standard” covers a lot of ground — not losing money in a quarter, or earning at least 10% a year, are both objective standards.  But indices are uniquely well-suited to be the standard by which asset owners evaluate asset managers.

Most broad market indices — whether they measure equities or bonds — are capitalization-weighted.  Such an index will accurately reflect changes in the total market value of the asset class in question.   One of the most important characteristics of any asset class is that there is no net supply of alpha.  In other words, one manager can be above average only if another manager is below average.  The aggregate amount by which the above-average managers outperform the asset class must equal the aggregate amount by which the below-average managers underperform.

By comparing manager performance to that of a well-diversified, cap-weighted index, an asset owner realizes two benefits:

• He assures himself that his bogey is reasonable in view of the opportunity set available to his managers.  In 2011, with the S&P 500 up 2%, it would have been foolish to expect a U.S. equity manager to meet an absolute 10% bogey.  This year, with the 500 up 29% through November 30, it would be equally foolish to be satisfied with 10%.
• Since there is no net supply of alpha, roughly half of all managers will outperform their asset class and roughly half will underperform.  As a convenient shorthand, a manager who beats a well-diversified cap-weighted index is likely to be an above-average manager.

There are as many putative paths to outperformance as there are active managers (or active managers’ marketing departments, which is more or less the same thing).  None of them will be impeded by asset owners’ use of well-chosen indices to evaluate manager performance.

Globally, over 6 billion U.S. dollars are invested in India Equity ETFs, although less than 200 million via products listed in India.  It’s reasonable to suppose that Indian demand is reflected in the local figures, transferring wealth across Indian borders is both difficult and expensive.  Thus, on the face of it, these figures suggest general indifference to passive investing within the Indian financial community, despite substantial passive interest in India from outside its borders.

The debate between proponents of passive and active investing has been raging for close to a century.  And when it comes to India, the evidence favours the passive investor, much as it does in more-developed markets.  But – in India as much as elsewhere – very few investors are limited to a single asset class.  From the perspective of a multi-asset portfolio, the real picture is much more complicated, and potentially more rewarding.

When looking across asset classes, there is no universally-agreed definition of what ‘the market’ actually is.  In the absence of a widely-accepted bogey, in practice investors frequently build their own: a benchmark comprising a custom blend of markets across a variety of asset types and geographies, representing their overall allocations.  And here’s where it gets interesting.  The impact of changing asset allocation is usually much more significant than changing an individual component benchmark, or changing a component between active or passive allocations.   An investor, manager, advisor or consultant adds the most value when he gets his asset allocation right.  And given the time and effort spent on choosing individual managers, arguably the most efficient way for an investor to spend his time is to focus on actively managing an asset allocation among passively managed components.  In fact, a key driver of ETF growth across the world – ranging from US financial advisors and institutions, European macro-funds and through Asian retail investors – is through such active management via passive asset allocation.  Sometimes old foes can find a new partnership.

These are important considerations for investors in India and elsewhere.  To learn more, please join us for a live 60-minute webinar on December 12, 2013 to hear from practitioners at Kotak Mutual Funds and S&P Dow Jones Indices.  We’ll discuss the trends, opportunities and challenges in investing actively through passive building blocks.

Robert Shiller, Yale economist and author of Irrational Exuberance, who warned of 2000 Tech bust and the housing bubble is warning that equities may be a bubble. Year to date, the S&P 500 is up 26.7% and the Dow Industrials are up 22.4%, both before dividend reinvestment.

It may have been 30 years ago, in the early days of stock index futures, that the verb “equitize” (and its cognate noun, “equitization“) came into relatively common use.  The term, if Dr. Johnson will forgive me, meant “to provide equity returns without purchasing equity securities.”  Typically this was accomplished by buying S&P 500 futures — if I had a $10 million cash position, I could “equitize” it  by buying S&P 500 futures with a notional value of $10 million.  Unless I’d made a severe arithmetic error, the total return of my cash + futures position would very closely approximate that of a $10 million S&P 500 index fund; hence my cash had been equitized.

For unknown reasons, “bonditize” or “bondize” never caught on.

I propose that indicize (and its noun form, indicization) will sooner or later find their way into common use.  To offer an inelegant definition, indicize means to provide, in passive form, a strategy formerly available only via active management.  Consider, e.g., a hypothetical investor who wants to tilt her portfolio toward small-cap growth stocks.  Thirty years ago, her only option was to buy a mutual fund whose manager avowed a specialization in small-cap growth, and then to hope for three things:

1. That the manager shared the investor’s definition of small-cap growth
   
2. That the manager didn’t change his mind (for instance, by deciding that large-cap value offerered better opportunities this quarter) during the investor’s holding period
3. Most importantly, that the manager’s stock selection ability, if not positive, was at least not so negative that it overcame the putative benefits of being in small-cap growth in the first place.

Since then, of course, advances in passive management mean that a strategy like small-cap growth is easy to indicize.  (Today our hypothethical investor’s main problem would be to decide which of several ETFs or mutual funds specializing in small-cap growth she’d prefer to buy.)  There’s no need to expose herself to the vagaries of active management when a passive solution can provide efficient and inexpensive exposure to the factors about which she really cares.  And of course indicization isn’t limited to size and style portfolios, but extends to other themes — low volatility comes immediately to mind — as well.

This makes the active manager’s life harder.  In former days, he could expect to be paid both for providing access to factor exposures as well as for stock selection; today, he’s increasingly limited to stock selection as factor exposure is indicized.  For the same reason, indicization is an unambiguous benefit for the investor.

The Fed’s QE policy is credited with, or blamed for, inflating prices of homes and stocks. The forces pushing prices up in these markets may be the same, but buyers’ perspectives are very different.  When the S&P/Case-Shiller home price numbers were released yesterday (November 26^th) there were fears that bubbles were back, especially in San Francisco and two notorious housing markets: Phoenix and Las Vegas.  `The stock market story is different.  It has risen farther, faster and for longer than homes.  For each commentator or forecaster who evidences nervousness, there are three, four or more ex-bears abandoning fear and buying stocks.  Everyone says the market can’t go up forever, but they also expect it to keep rising.  There is a minority worried about bubbles or crashes and an even smaller minority selling stocks or buying puts.

The S&P/Case-Shiller indices show that monthly price gains have been shrinking since April.  As home prices rise, some would-be buyers are priced out of the market or into smaller homes.  Further, rising prices attract new sellers, increasing supply and leading to smaller price gains, or even declines.  This is the way most markets work.  Current market sentiment and supply-inducing price increase make bubbles in house prices unlikely. Stocks are different: rising prices of either specific stocks or indices attract more buyers. The different reactions in house and stocks affect the market sentiments; and the sentiments drive the markets.

Why aren’t more people worried about the stock market?  The most common answer is fundamentals.  Earnings are rising, the PE ratio is close to its long term average, and we’ve reached these levels before without a collapse.  Looking back to the period since the market bottom in March, 2009, earnings and stock prices have risen almost in tandem. Both the PE ratio and the price-to-book ratio on the S&P 500 are only modestly higher than when the current bull market began.  However, some members of that minority of worriers are looking farther back.  Corporate earnings as a percentage GDP are at record levels. Moreover, the ratio of corporate earnings to GDP tends to mean revert – when it gets too far out of line, it heads back towards its average.  Sustaining strong earnings growth will require strong GDP growth, something we haven’t had much of lately. Maybe the Fed’s QE will work its magic on GDP growth.