How Smart is Your Index?

Albert Einstein - Caricature







How “Smart” is Your Index?

A while back, we looked at some of the alternative arguments for active and passive investing. Why pay high fees to an active manager when the average manager doesn’t beat his benchmark? (Hint; find a top quartile manager!) The debate rages on and most likely will continue forever. There are always managers touting superior performance and there are always those focused on expenses and higher order allocation decisions. Of course, many investors fill the space in between, using active managers for asset classes that are more inefficient and passive for those that are very efficient. While many studies have been conducted to test the value of active management vs. passive management, there has been very little research conducted on some of the different ways that investors can now invest passively. A recent article by Jason Hsu of Research Affiliates (“Measuring the “Skill” of Index Portfolios) looks at recent innovations in passive investing (i.e. Smart Beta Strategies) and analyzes the differences between those strategies and traditional index strategies. Along the way we are forced to re-examine our assumptions regarding traditional indexing.

Index investors believe that active managers do not add value over time. In Yale professor Burton Malkiel’s classic text “A Random Walk Down Wall Street”, he argues that the stock market is efficient in that all known information is reflected in today’s stock prices and that no advantage can be gained by the research and analysis of active  managers. The title of the book suggests that stocks can be selected randomly, since all information is already reflected in stock prices. Does this mean, however, that investors in traditional index funds can attain the same return as uninformed investors? Hsu says that “uninformed investors cannot distinguish between good stocks and bad stocks, and their portfolio returns will deviate from the return of an average stock in a random manner”.  

Traditional index funds do not treat investing in the stock market as a random exercise. There are, in fact, rules that determine the asset allocation of an index. The S&P 500 index is a cap-weighted index, which means that the stocks with the highest market value have the highest allocation and conversely the stocks with the lowest market value have the lowest allocation. (Buy High, Sell Low Anyone?). These traditional cap weighted indices are by far the mostly widely used in index investing. However, the allocation process is hardly random and does not represent the “average” stock or average market of stocks.

“Smart” Beta funds are simply index funds with different (allegedly “smarter”) allocation rules. A prominent new competitor to cap weighted indices is the “fundamentally” weighted index, which allocates more to stocks that meet certain criteria related to fundamental accounting measures such as return on equity, sales, cash flow etc. These criteria in fact begin to resemble some of the screens that active managers use, but do not incorporate projections that active managers typically make when allocating.

Hsu’s research used widely accepted methods of identifying manager skill and looked at 5 different strategies, including 3 “smart beta” strategies, a cap weighted traditional index strategy and an equal weighted, or random, strategy. While it may seem obvious that there was no skill attributed to the random strategy, it is interesting that all 3 of the smart beta strategies showed virtually no skill while the cap weighted index showed “negative” skill of over 200 basis points (2%).

This research highlights 2 important things for traditional index investors. First, index funds do not truly represent “the market” because they have allocation rules which favor recently strong stocks over recently weak stocks. Secondly, the allocation rules used in cap-weighted indices are “less skillful” than those used in fundamental index strategies.


About Jim Jeffery, CFA

Jim Jeffery, the founder and principal of Jeffery Asset Management has joined Solaris Advisors LLC as Managing Director where he will lead the non profit senior living effort. Jim is a Chartered Financial Analyst (CFA) with more than 20 years experience in the financial services industry. Have a question about your financial plan? ASK JIM

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