|Excerpt from the book’s foreword
The Role of Indexing and Benchmarks in Developing Sound Investment Approaches
Managing Director, Morningstar
Simple ideas can have profound consequences. Just consider the revolutionary effect that indexing has had on the investment markets. From the simple notion of creating a benchmark of the market, a host of radical changes have emerged that have given investors greater control in managing risk, return, and cost in their portfolios and raised the bar for active managers. The changes have been profound, positive, and permanent. From almost any angle one looks, the power of indexing and the impact it has had on investment markets are difficult to overstate.
Indexes, of course, serve as a gauge of the market, but they also do much more. They are -the basis for asset allocation research. Much of what we now know about the relative impact of asset, sector, and security selection on portfolio performance owes to work derived from indexes. They are also tools for performance measurement, creating increasingly better standards by which to evaluate managers. But, perhaps most significantly, indexes are now often the basis for investment vehicles. No longer can a fund manager take credit simply for offering the investor broad-based exposure to the market. Today, that service can be had for pennies through index funds. If a money manager wants to charge higher fees, he or she must demonstrate that their services provide added benefits. In a very real sense, the growing popularity of indexes and index investing has forced all money managers to raise the level of their game.
Indexing has been at the heart of a process that’s moving the investment profession from art to science, which in turn brings significant value to all investors. Beyond the considerable cost savings of index-based products versus conventionally managed ones, indexes yield many other significant benefits. By establishing clear benchmarks, indexes serve as performance measurement tools that bring a needed precision to manager evaluation, increasing the likelihood that an investor identifies and retains higher-quality managers. In addition, managing to a stated benchmark helps ensure that the manager and the client’s understanding of a fund’s objectives are in sync, thereby making it easier to understand what role in a portfolio the fund will play. Simply put, proper benchmarking is a powerful tool for increasing an investor’s chances of investment success.
But where indexes get really interesting is when theory turns to practice. The wave of investment products based on indexes has been remarkable, both for their variety and their popularity. With index funds, exchange-traded funds (ETFs), and a host of index-based derivative instruments, the tool kit at an investor’s disposal has never been deeper. While some money managers may perceive index-based alternatives as a threat, investors should cheer their arrival. Even if an investor continues to favor active managers, the availability of lower-cost index strategies only improves the investor’s chance of success.
The benefits of index strategies are perhaps greatest if investors think of index-based products not as being on a straight-line spectrum that runs from actively managed funds to passive indexes, but instead thinks of the spectrum as a horseshoe that on one prong offers low-cost, index strategies and on the other prong offers exceptional managers at reasonable costs. Either approach is attractive and the two can easily be combined.. What a smart investor will do is seek to purge the bottom part of the horseshoe from his or her portfolio, that being not particularly creative or effective management at high fees. Sadly, that’s the vast majority of funds out there. Still, with the advent of index funds, and the added pressure on good managers to deliver strong returns with reasonable risk, the number of suitable choices facing an investor has never been greater.
Indeed, index-based investment products are powerful tools. They offer greater precision at lower cost than actively managed portfolios. To exclude them from your arsenal without proper consideration of their merit would be foolhardy. For one, index products offer purity of style or asset-class exposure. With an index fund, what you see is what you get—the ultimate in truth in labeling. Index-based products also remove ambiguity as to who is making the asset allocation decision. There’s no need to worry about a manager going to cash when your intent is to be fully invested. Indexes also can remove security selection risk for all or any part of their portfolio. If you think biotech will rally, but you’re not sure which stocks will do the best and you don’t want the risk of selecting a manager who picks wrong, there’s an index-based solution at your disposal. Whether you use index funds/ETFs as your entire portfolio, as building blocks of a portfolio, or to fine-tune an already established portfolio, indexes and the products build from them are invaluable tools you’ll want in your investment toolkit.
One significant reason to include indexes among your options is the transparent availability and legitimacy of their performance record. Indexes offer long histories of how a certain approach to the market works in all sorts of environments. While the returns of actively managed funds lose legitimacy as managers come and go or styles change, the consistency of an index strategy makes the entire record of the index germane to the investment decision. If you want to get a sense of the stock market’s long-term potential, you should turn to a series of broad market indexes. This facet of indexes is a boon to investors who seek to understand the long-term implications and potential of their choices.
A final reason, which bears repeating, is the significant cost savings of index strategies. At a time when mutual fund expenses continue to creep inexorably upward, the low-cost alternative of index investing appears increasingly attractive. Within the world of indexing there is true cost competition. Who would pay 120 basis points for exposure to the same index that another firm offers for 20? In an era of lower absolute returns for both stocks and bonds, the cost savings of index strategies makes tremendous sense. There’s also the issue of tax efficiency, another score on which indexes have saved investors huge sums of money and put more pressure on active managers to focus on the tax costs of their own trades. Lowering your costs and tax burden are two of the “sure thing” actions an investor can do to enhance return without incurring added risk – which is essentially a free lunch. Index-based investment products are a great tool capturing these two ‘free lunches.”
With all the positive changes that the index revolution has brought to investing, you’d think that the field would be crowded with books documenting the origins and subsequent ascent of indexing in the marketplace, but it’s hardly the case. While the field may still not be crowded, it can certainly no longer claim to be underserved. Steven Schoenfeld has produced a remarkable book that features not only his own considerable insights, but also the perspectives of numerous leading practitioners from all spheres of the indexing world. The book’s scope is immense, covering the genesis of indexing, their use as benchmarks, the development of an ever-expanding range of index products, the art and science of index-based portfolio management, and finally, examples and case studies on how the world’s most sophisticated investors use indexing to minimize costs and risks and maximize returns.
Fittingly for a project so broad, the book’s scope doesn’t end with the physical book, but is continued here, in the book’s E-ppendix, expanding the book’s coverage and allowing even more voices to help chronicle the ongoing development of this fascinating and dynamic field. The book itself is encyclopedic. It covers not only the history of indexing to date, but also marks out the terrain the industry is likely to cover in its continuing evolution. If you follow the investment markets and you want to see how indexes and index-based tools and strategies will continue to shape the markets, you’ve found what will surely become one of the definitive books and websites on the topic. I am sure that you’ll gain from the journey.