Investing: What is an Index?

Investors have benefited tremendously from the growth and evolution of indices, and their use in performance management can keep active managers honest  

Ben Johnson 22 January, 2019 | 12:17PM
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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 a Changing World

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 mutated into a form of what they've long been used to judge: active management. This is evidenced by the growth of strategic or smart beta exchange-traded products, or ETPs. 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 metamorphosis from measure to target to active management has sucked the meaning out of the term "index". I would argue that "true" indices are those that most broadly measure a segment of the market. That implies full market-cap coverage and market-cap-weighting. Anything different begins to inch across the passive-to-active spectrum in the direction of active management.

Active Strategies in Index Form

Indices will keep 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.

Indexing will inevitably expand to new frontiers. There are corners of the market that will become more accessible over time. As this happens, investor interest will grow and along with it the demand for indices to measure these market segments and obtain exposure to them via index funds.

Investors have benefited tremendously from the growth and evolution of indices. Their use in performance management keeps active managers honest. Their use as the basis of index funds and ETFs has reduced the cost of investing and given investors an alternative to active management. Their more recent transformation has further tightened the screws on active managers, delivering a new form of active management at a competitive price point. Indices have been a disruptive force, and I expect that they will continue to tilt the landscape in investors' favour.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

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