Active Index Investing's E-ppendix
Active Index Investing's E-ppendix


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May 31, 2016 11:28 am. EST  

 For Novices

Much Ado About Index Investing

Index investing, commonly referred to as 'passive' investing, is an investment technique that attempts to mimic the performance of the benchmark index - S&P 500, Dow Jones Industrial Average, etc. - that they are pegged to. These benchmarks provide the daily changing prices as well as history of the featured market; thus providing a point of relevance to which investment performance may be measured against. An important thing to keep in mind is that these benchmarks should only be used to measure their respective asset classes or subclasses. For example, the S&P 500 benchmark would be used to measure a portfolio of large-cap stocks while the S&P 600 would be used for small-cap.

An index fund manager trying to duplicate the performance of, say the S&P 500 index, would hold most or all of the constituents of the S&P 500, so that the performance of the fund would be in close correlation with the index; the fund would therefore rise and fall with the index. In addition, decisions such as defining the index’s focus and scope, selecting securities that will be included in the portfolio, determining the weighting scheme of the index, setting a baseline value are made by the index fund manager. One of the key themes of the book is that 'indexing is anything but passive,' but first you'll want to know a bit more about what indexing is and why it has grown so much since its humble beginnings.

Index investing has enjoyed a tremendous boom in popularity in the past three decades. When first introduced in the early 1970s, indexing was mainly the domain and obsession of academics who theorized that a strategy of owning portfolios that track selected benchmarks offered a number of significant advantages over one of attempting to outperform that benchmark. By the late 1980s, indexing had become increasingly embraced by both mainstream retail and institutional investors, enjoying a growth rate of 20% in the tax-exempt marketplace since 1988. Today, approximately $2.4 trillion of institutional assets worldwide are invested in index funds, with about $1.4 trillion of that being US-tax-exempt institutions, representing about 25% of total institutional funds.

One of the primary index management techniques is full replication, which is the ultimate 'passive' form of investing since the manager holds everything that is in the benchmark index. In this case, the difference between the return of the index fund and the benchmark index, known as 'tracking error,' stems only from expenses and fees in managing the fund. That being said, as will be described in Part IV of the book, index changes, corporate actions, and IPOs, as well as inflows and outflows of assets, still require significant portfolio management skill to manage. Other index investing techniques are less passive and are more accurately described as 'active' index investing. These techniques require the index manager to replicate the main characteristics of a benchmark index with a portfolio of fewer stocks than the benchmark index. These types of index investing techniques - known by such names as stratified sampling, optimization and blending approach - are not as passive in that managers must choose which stocks to include or exclude from the portfolio based on models and tools honed through rigorous quantitative research.

What Index Investing Can Do For You

The main advantages of index funds are that they have lower management fees, provide diversification, offer competitive performance, and are tax efficient. Furthermore, with index funds, choosing a fund manager becomes much easier because his performance is transparent.

Lower management fees: Active fund managers engage in extensive research to decide on which countries, sectors or companies to include in a fund, and when to buy or sell, in order to beat a particular benchmark index. This is a very costly process that leads to higher management fees, but has not proven to help active managers outperform their benchmarks with consistency. By contrast, index funds, which are charged with replicating a set benchmark, do not incur such costs. Index investors focus their efforts on risk control and cost efficiency.

Active managers typically incur higher trading costs as they constantly buy and sell holdings based on their investment opinions. Index managers generally realign portfolio composition only to reflect index changes. Thus, turnover stays comparatively low at around 3-15% of that of the active manager, eliminating a great deal of costs inherent in portfolio management. Successful index managers have generally approached the asset transaction process as a science since efficient management of portfolio turnover is critical to successful index fund management.


An important aspect to maintaining a balanced portfolio is to keep it diversified. Choosing stocks using criteria based on individual merit alone will commit much of an investor's capital towards stocks that shift in the same manner (e.g.- blue chip stocks, technology stocks.) Although these selections will provide returns during times of strong performance, they will also deliver negative returns during sector downturns. Thus, a diversified portfolio will provide benefit from flourishing stocks throughout the economic cycle, providing an offset to those stocks that have shown negative returns.

A truly diversified portfolio invests in various asset classes including large cap stocks, small cap stocks, international stocks, bonds, etc. The best way to maximize diversification, especially for individual investors, is to invest in index funds that guarantee that an investor's money will be spread over the entire market. For example, an investor can be fairly well diversified by investing in a fund that tracks the Russell 3000 index for US broad market, one that tracks the MSCI EAFE index for international exposure, and a fund that tracks the Lehman Brothers Aggregate Bond Index for global treasury, corporate and mortgage-backed fixed income exposure. By contrast, it would be pretty much impossible to get this level of diversification with the same number of actively managed mutual funds since each fund is generally restricted to a limited number of stocks that the active manager can devote a sufficient amount of time monitoring.

Tax efficiency:

Index funds buy and hold stocks longer than active funds because, as mentioned earlier, they buy and sell only to realign the fund with changes to the benchmark index. They do not buy stocks in anticipation of a market rally or sell in anticipation of a market pull back. Capital gains taxes are therefore minimized and usually less than active funds. And because money that would have been paid out as taxes can keep producing investment returns, the effect of delaying taxes is powerful over time. For taxable investors, separately-managed accounts can further add to the tax-efficiency of indexing.


Finally, one of the key drivers in the growth of indexing has been investors' frustration with long-term traditional active manager performance. When examining a universe of active equity managers against a popular index, say the S&P 500, the benchmark ranks close to the median active equity manager. After taking management fees into consideration, index funds seem even more attractive. Given the higher management fees charged by active fund managers, investors must be confident that they can choose a fund manager who can outperform their benchmark. If an investor doesn't believe in his luck or skill in picking an active fund manager, then he is better off investing in index funds that are aimed at matching the performance of their benchmarks.

Again, in choosing to invest in index funds rather than actively managed funds, an investor must be content with the average performance of a market, and not want to try to beat the market. Index investors are usually skeptical that an active money manager can improve on the average performance without raising risk. They are even more skeptical after hefty fees are subtracted.

If you need further evidence that indexing is the smarter way to invest, read The Great Mutual Fund Trap (Broadway Books, 2002) by two contributors to Active Index Investing, Greg Baer and Gary Gensler.

Expanding Index Flexibility

Why has index investing enjoyed such popularity, and what has been the engine of its growth? The acceptance of index investing as a core component of a well-diversified portfolio can largely be attributed to several factors as mentioned above. And as indexing has grown in popularity, investors are using indexed products and its derivatives in increasingly sophisticated methods to enhance performance, control risk and lower costs. (For more than just an intro about index derivatives strategies, Chapter 14, 'Ever Evolving Uses of Indexing,' is a must read.)

Institutional managers have traditionally led retail participants in investing trends, and growth of indexing is no exception. This is particularly true of Exchange-Traded Funds (ETFs), which are one of the fastest growing index vehicles used by institutional and individual investors.

What's an ETF?

Exchange-Traded Funds are index funds that are listed on stock exchanges and can be traded like a stock. They are similar in nature to index mutual funds in that they provide exposure to broad market segments and their success depends upon their ability to track their respective benchmarks. ETFs have several additional benefits that we will talk about below that have led to their explosive growth. Since the listing of the 'Spider' (SPY) in 1993 to track the S&P 500, the number of ETFs trading around the world has risen to about 257 including 106 listed on U.S. stock exchanges. These ETFs, evermore diverse to meet the demands of institutional and individual investors, track broad equities, bonds, sectors, countries, and regions. Assets invested with domestic ETF managers have increased to approximately $120 billion as of July 2002 from $460 million in 1993, an annualized growth rate of about 70%!

Benefits of ETFs

While index funds were tools available only to institutional managers for managing portfolios, ETFs, which can be bought and sold by any individual on stock exchanges globally, can be a tool for individuals to manage their self-managed portfolios. Essentially, ETFs give investors both the flexibility of a stock and the diversification of an index fund. While most mutual funds are priced at their Net Asset Value (NAV) at 4:00 p.m. ET daily, the price of the ETF changes in real time throughout the day. ETFs can also be bought on margin (money borrowed from your broker) and sold short. Unlike regular stocks, ETFs can also be sold short on a downtick (in a market that is moving down).

In addition to having both the benefits of flexibility and diversity, the expense ratios for most ETFs are extremely low, even when compared with traditional index mutual funds.

Diversification in ETF's

As with index funds, with a single transaction in an ETF, such as the MSCI EAFE iShares, an investor can track a broad index strategy that may otherwise require over 1,200 individual stock transactions traded in over 21 countries with multiple currency transactions and settlements operations. ETFs can offer the individual investor the same efficiencies and cost benefits traditionally provided to large institutional investors.


Unlike traditional mutual funds that can only be purchased or redeemed at the close of the trading day, ETFs can be bought or sold throughout the trading day, giving them intra-day liquidity. An ETF investor anticipating adverse news in the market can readily sell his shares at any point during the trading day.

Tax efficiency

The mandate for ETFs is to match their respective benchmarks as closely as possible while maintaining tax efficient performance (which as two seasoned ETF managers demonstrate in Chapter 20, 'Managing Exchange-Traded Funds,' takes quite a bit of planning and strategizing!) Designed to be tax efficient investments, ETFs shield investors from tax burdens common to active mutual funds in two ways. First, like index funds, ETFs tend to offer greater tax benefits because they generate fewer capital gains due to low turnover of the securities in the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Second, exchange trading of ETFs further enhances their tax efficiency. Investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure of ETFs, managers of these funds are not required to sell securities to meet investor cash redemptions, which would potentially generate capital gains tax liability for remaining investors. The sale of an ETF will generate capital gains/losses only for the investor liquidating shares.

By contrast, when mutual funds shareholders redeem shares, they are paid directly by the fund company. If the fund company does not have enough cash in the fund to meet the redemption, it must raise that cash by selling securities in the portfolio. If the fund company should realize a gain on these sales, the gains are passed on directly to all the shareholders. In other words, the action of one shareholder may result in tax liability of many shareholders!

Due to their inherent nature, the in-kind mechanism, lower portfolio turnover, etc., ETFs should generally prove to be tax efficient instruments. In most cases, this means the fund pays very little in the way of realized capital gains that can be taxed at higher rates to individual investors. If you thought taxes could not make interesting read, then you'll be pleasantly surprised with Chapter 23, 'Tax Efficient Indexation,' as it shows you how much you can save by indexing.


In its most basic form, indexing is achieved by constructing a portfolio of assets to replicate the returns of a specified benchmark index. At the other end of the spectrum is active management where the objective is to outperform the index by taking explicit bets away from the index. As managers seek to enhance the process of replicating the index return, they move along the risk-return spectrum away from pure index management. Here, somewhere between passive and active management lies enhanced indexing. The objective of enhanced indexing is to add return in a risk-controlled environment without completely shifting toward the unintended bets of the active management framework. It is different from low-risk active management in its objective to control risk by replicating specific characteristics of the benchmark. As such it controls unintended bets against the index.

Enhanced indexing has two basic objectives that correspond with those of active management and passive management. The first objective is to outperform the index, and the second is to maintain the same risk characteristics as the index. With these two objectives in mind, an enhanced index fund generally seeks to outperform an index benchmark by up to 1.5%.

This extra return, technically known as 'alpha,' can come from a variety of sources. Some managers will use leverage to enhance. That is, they may have the opportunity to borrow money at X% and invest it in an index fund that generates X+1% return. Some will employ a 'sampling' technique where they hold a subset of the benchmark index, therefore boosting return by cutting transaction cost. Still others will use various derivatives. There are many other methods to manipulate the index to produce a desired result and they are by no means passive. If you are curious for more on this hot topic, you might want to take a read through Chapter 13, 'Enhanced Indexing - Adding Index Alpha in a Disciplined, Risk-Controlled Manner.'

Risks in Index investing

Notwithstanding the many benefits of index funds and ETFs, investors in these products are still subject to the risk that the most well diversified portfolios are subject to, and that is market risk, or the risk that the general level of stock prices may decline. An index fund that is benchmarked to a sector index or exchange traded sector fund may also be adversely affected by the performance of that particular sector or industry on which it is based. Furthermore, international investments may involve risk of capital loss from unfavorable fluctuations in currency values, differences in generally accepted accounting principles, or economic or political instability in other nations.

The bottom line is that markets will go up and they will go down, and that is something that neither index nor active investors can avoid. But with index and index derivative investments, you can feel assured for all the reasons we've cited - lower fees, tax savings, etc. - that you are paying less to your fund manager and less to the IRS than those investors in actively managed funds, and that you are getting returns that are at least on par with them!

So, we hope that this introduction entices you to learn more about indexing. Greg and Gary's book, The Great Mutual Fund Trap is a good start, as are some of the websites listed below, and the more extensive list in our links section. And learning more basics now will provide a great foundation of knowledge for you to read the definitive book on indexing, Active Index Investing.


Pensions & Investments - Watch out, active managers, for the new EAFE-- An article by Steven Schoenfeld featured in the November 12, 2001 issue of P&I

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