Japanese Translation Book Review by Ryu Jubishi – GPIF
As published in the Securities Analyst Association Journal, July 2006
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Active Index Investing
–The Cutting Edge of Indexing Management–
Edited by Steven A. Schoenfeld
Translation supervised by Yukihiro Asano, Yokohama National University
Translated by Indexing and Quantitative Investment Management group, Sumitomo Trust & Banking Company, Ltd.
(Toyo Keizai, Inc.)
In the past months I have been studying issues on benchmark indexes as one of the themes to be researched by my organization for fund management. I will be raising the following questions:
1. The definition of the investment universe is a critically important issue for pension funds. In order to acquire as many investment opportunities as possible, for all of every asset class, shouldn’t a benchmark index as broadly diversified as possible be adopted?
2. In passive management, however, the number of stocks composing an index portfolio and their liquidity significantly influences the performance. If that’s the case, won’t there be a problem using indexes that include small caps and stocks from minor markets such as emerging markets in a portfolio?
3. Meanwhile for efficient active management, it is desirable to build a fund management structure taking advantage of the individual managers’ specialties. However, then, what kind of a bench mark mix is needed to enable such a style of management and still provide individual managers with chances to pursue alpha strategies?
4. How should the consistency of the relationship between the benchmark index of all asset classes in asset allocation and mixed benchmark indexes to be pursued by individual managers be considered?
5. Now, when you try to utilize the variety of benchmark indexes for efficient management based on the above, what kinds of investment products can be provided by the asset management institutions?
Active Index Investing will be useful not only for my organization but also for anyone who wants to get answers to benchmark index related questions. This book was compiled by the editor who has long active experiences in index management, collecting contributions from over fifty experts and practitioners in the industry. It covers a wide variety of topics on index investing theories and practical management. What makes the book so unique is that it provides detailed and practical descriptions on a wide variety of topics on indexing management by insiders of the US index management industry. The book will no doubt reveal to its readers the current situation and expected development of the US index management industry. The book consists of twenty-five chapters (the original edition has thirty-one chapters) divided into five parts, and each section looks into independent topics on index investing. Due to this format, the reader may read only sections of his or her interest, but by reading through to the end, the reader will be better able to understand the views and opinions of the editor and contributors that are repeatedly mentioned throughout the book.
Before unfolding the discussion, the editor placed a chapter titled “Indexing is Active" as an introductory chapter. Why is index investment, active? The editor gives the following three reasons. First, the composition and selection for a benchmark are active.
Secondly, the management of index fund is active. Thirdly, index products can be actively utilized if investors wish to utilize them as such. The title of the book “Active Index Investing” represents the belief consistently asserted throughout the book that index investing is not passive and by the active integrating of indexes and related products in the portfolio by investors, sophisticated portfolio management can be conducted.
Part One, “The Indexing Revolution - Theory and Practice –“goes into fundamental arguments on the basic theories and practices of index investing. First, due to the development of index investing, making the choice between index or active management a thing of the past, the perception in which investors will in the future appropriately combine index and active management will be presented. Following that, by also illustrating the advantages of index investing, such as “easy risk budgeting” and “low management fees and costs”, the prevalent view that “index investing is only effective in a bull market” is repudiated. Then, new products such as ETFs (Exchange Traded Fund) and the index-based derivatives, as well as new strategies that combine index and active management, such as the single and multiple asset class core strategies, asset allocation overlays, and optimization strategies are introduced.
Further, based on experiential data on how index investing will perform against the risk of market uncertainty, the contention that for successful long-term return, it is desirable to have core asset allocation with such index funds, which require low costs and minimum monitoring is developed.
In Part Two, “Benchmarks: The Fundamentals of Benchmark Index Investing,” discusses how to utilize indexes and how to construct benchmarks. First, four ways of using indexes are indicated: (i) as a benchmark of market sentiment, (ii) as a criterion for evaluating managers’ performance, (iii) as a tool for planning asset allocation strategies and monitoring, and (iv) as a criterion for choosing investment methods. Then, seven key criteria of satisfactory indexes such as “completeness” and “investability,” and five trade-off factors inherent with construction and selection of indexes such as “completeness and investability” and “reconstruction and rebalancing frequency and turnover” are presented. Further, basic guidelines for constructing ideal indexes such as objective rules, floating stock adjustments, and fluctuation range settings are indicated. Based on the above-mentioned general theory, the second half of Part Two provides detailed discussions specifically on actual benchmarks for each asset class. Points are organized based on new trends, and cover benchmarks for not only U.S. stocks, global equity, and bonds, but also for hedge funds and SRI indexes.
Part Three “The Variety and Flexibility of the Expanding Index Products” focuses on index-based investment products growing quickly in recent years. First, readers will be introduced to enhanced indexing in which alpha performance is achieved steadily with the focus on risk control, the ETF that is expected to further grow as a flexible and effective investment method, and for the indexing in the real-estate market, the current status of products and how to use them. Then, comes the chapter ,“Active Indexing”, which summarizes Part Three by introducing cases of the possibility of active portfolio management in risk adjustments in investment strategies using index products, using derivatives and ETF to determine the market exposure level, or making use of indexes to implement weighting strategies.
Part Four “Managing Index Funds: Anything but Passive!” introduces index portfolio management in practice. Methods of index portfolio management include the method of perfection, stratified sampling (linear optimization), sampled optimization (quadratic optimization), and approaches mixing these methods, and the individual construction methods as well as advantages and disadvantages of these approaches will be uncovered. Following this, the practical challenges of index fund management are laid out, such as the handling of changes in indexes and corporate actions, the minimizing of transaction techniques and transaction costs, cash management, risk management, and securities lending. Then, the unique challenges in equity index portfolio management in the U.S. market such as market size and coverage, trading strategies and derivative markets, as well as the unique challenges for securing good execution in the global equity index portfolio management, such as currency risks, foreigner equity acquisition restriction, and how to assure best execution in trading is uncovered. Further, separate chapters dedicated to such topics as management and risk management methods of recently growing bond index funds, and the management method of ETFs and its unique challenges have been provided.
Part Five “Pulling It All Together: How to Effectively Use Index Products to Implement an Efficient, Risk-Controlled Investment Strategy” details how institutional investors are able to benefit from a vast variety of index products. First, five ways to obtain equity index returns (cash stock portfolios, stock index futures, ETFs, index swaps, and index options) are provided with management guidelines and characteristic clarified for each. Following this, examples of using index funds for pension plans are introduced. Readers will learn that index funds are being used for pension funds for such purposes as constructing efficient manager structures, implementing asset allocation strategies, and constructing active portfolios, and the best approaches for carrying out these strategies such as internal management and outsourcing, single and joint management, and so forth are presented. Then, four tactics needed for successful long-term investment are laid out: (i) diversified asset allocation, (ii) risk-budgeting to determine appropriate manager/strategy allocation, (iii) consistent rebalancing, and (iv) rigid cost control. The argument follows that placing indexing at the core for investment strategies is recommendable from this viewpoint. The last chapter of this book is titled, “The Future of Indexing: The Revolution Has Just Begun!”, and presents Mr. Schoenfeld’s perspective on how the growth of index products in the future will progress. The editor concludes by envisioning a bright future for both index products and the investors who use them by pointing out that enhanced indexing, ETFs, index derivatives, and alternative asset indexing will indeed continue.
While stocks are being adjusted for free-float and “the third-generation index” with subindexes for each style is about to become available as a tool, investors on the other hand are starting to discuss new indexing approaches such as fundamental indexes not weighted by market capitalization. To select and utilize suitable index products for efficient portfolio management is a key issue for Japanese investors as well.
Thus, this book which will serves as a road map for index management is well-timed, and the efforts made by the individuals involved in publishing it in a short period are very much appreciated. I would also like to mention that the development of the book’s website – called E-ppendix by the editor – will be very useful for readers when searching for reference documents and latest information. In addition, due to the fact that the original book was quite long with nearly seven hundred pages, the chapters and columns discussing topics unique to the U.S. markets were omitted in the translated edition. Although it is possible that some readers may feel that many hints for future trends in index investment may be contained even in those omitted chapters, I hope that those readers are inspired to read the original edition.
(Fixed price including tax: 5,250 yen)
Executive Managing Director
Government Pension Investment Fund