The evolution of indexes has taken benchmarks from being almost entirely inactive to highly active.
For roughly 40 years now, one of the biggest decisions investors have had to make could be boiled down to three words: Active or passive?
The answer to that simple question said a lot about an investor’s beliefs about markets and investing. Active funds are those run by managers trying to outmaneuver and outperform the broad market, while passive funds mirror an index, allowing the investor to capture the market’s gains over time.
It has been widely accepted in recent years that indexing generally wins out in the long run, its combination of low costs, low turnover and high tax efficiency being the irresistible force that active managers can’t outrun forever.
But as index funds and exchange-traded funds (ETFs) have become the standard for the investing industry, they also have changed. While investors can still choose from the very first indexes that were turned into funds — such as the Vanguard Index 500 (VFINX), the world’s largest mutual fund — they also can get seemingly endless new varieties.
The situation defies imagination as the number of index funds and ETFs currently stands in the thousands, while the Index Industry Association recently revealed that its members are running 3.288 million indexes.
Not every index is “investable” or suitable for being turned into an index fund. But there would be no reason to maintain this mass of benchmarks if managers weren’t trying to improve the way they slice, dice, measure the market in the search for the proverbial better mousetrap. That is, a product better than your competitors.
As recently as five years ago, the U.S. Patent Office had issued over 4,400 patents on mousetraps, and was getting 400 new mousetrap applications every year. The trouble is, most patent experts think only two dozen of those approved patents ever made any money.
The same can be said for indexes, where only a few are likely to prove to be better than the originals they are built to replace or supplant.
Jack Bogle, founder of the Vanguard Group and of the first index fund, says that for all of the new indexes out there — including many used in funds run by Vanguard — most people would be best served sticking long-term with traditional, legacy indexes.
Consider, for example, the Dow Jones industrial average, the most widely quoted benchmark. It was started in 1896 and has 30 stocks purported to represent the industrial sector. General Electric is the only original stock still in the Dow, but these days companies like McDonald’s and Goldman Sachs are part of the “industrial” mix.
Despite what most experts see as structural shortcomings, the Dow has an average annualized gain of roughly 9.5 percent over the last decade.
By comparison, the Industrial Select Sector SPDR (XLI) — which is better diversified and uses a more modern methodology — has gained roughly 9.4 percent per year, and the much more diversified S&P Composite 1500 Industrial Index (not currently used as the basis for a fund or ETF) is up just 9.25 percent, on par with the classic S&P 500.
While I could craft examples to come up in many ways, the point here was to show that three different measures of “industrials” generated different long-term results, alternatively beating and losing to “the market” as measured by the S&P 500. Like cost differences, those return discrepancies would add up over the decades.
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Still, investors are now trying to pick the “best” indexes, a search that is almost certainly as futile as trying to find active managers who can beat the market for the next few decades.
“Clearly, we have a bull market for indexes,” said David Trainer, president of New Constructs, a Nashville-based research firm, “but if you lined them all up and looked at the holdings and strategies, you’re not really going to be able to tell one from the other and say ‘This is the best.’ That won’t stop people from telling you they’ve got something better, but you won’t know if it’s true for decades.”
The evolution of indexes has taken benchmarks from being almost entirely inactive to highly active. Some so-called smart-beta strategies confuse “index” for “passive,” because they are structured to make regular moves designed to beat the market.
Rick Redding, CEO at the Index Industry Association, says the new key question is “Active or passive or rules-based?” where active holds its traditional meaning, passive refers to traditional buy-and-hold index options, and rules-based applies to all of the new products — smart-beta funds included — structured to adapt to market conditions by regularly adjusting the portfolio.
“A lot of people are saying they’re passive investors, but the funds they’re buying aren’t really passive,” Redding said. “You can build indexes for large-cap growth, for example, in a lot of ways. Active management may not keep up with the best of those index funds, but it could be a lot better than the worst.
“Even the biggest indexing supporter can’t say that all indexes are great and that you just pick index funds and you win,” he added. “It’s about picking the right index funds, and that decision is probably going to keep getting more difficult.”