Active Index Investing
Steven A. Schoenfeld
Maximizing Portfolio Performance and Minimizing Risk Through Global Index Strategies
An elegant way to prove the superiority of 'passive' vs. 'active' management based on the hypothesis that the index represents the total market. Then index investing means owning a representation of the total market. Thus the rest, held by active manager, also represents the total market. (colinear vectors). The only difference: the active managers' fees.
There should not be any fight between passive and active management: index investing should be considered a default minimum-risk allocation for each asset class. Active strategies can build up on that core, depending on the investor's risk-appetite.
Money managers are usually following an sub-optimal contra-cyclical patterb when they try to time the market. Most of the market's cumulative return happens in a few days only.
Indexes are currently used to:
- gauge market sentiment
- benchmark portfolios perfomance
- set and monitor allocation policy
- serve as a base for investment vehicles
Market-capitalisation-weighted indexing is the only indexing way that offer macroconsistency: if every investor were index-investing, the investors / invested-assets universe would still be bijective.
Good indexes are float-adjusted.
The reconstitution effect is the price increase/decrease when a stock is respectively added/removed from an index. Does this reflect some value creation as per the index-membership hypothesis (greater liquidity and/or better information flow), or is it purely artificial? The measured effect is around 30bps. The effect is smaller with objective rules indices because investors can freely anticipate any addition/deletion. The effect has been shown to work quite counterintuitively: stocks removed from the Russell 1000 actually see their price increase because they fall into the Russell 2000, far more used in terms of investing benchmark.
Indexes should be built to follow how real investors see and segment the universe of stocks.
In the case of hedge fund indexes, should those include both open and closed funds to be truly representative of the industry's performance, or only open funds to be investable?
Problem with Hedge Fund indexes: the different biases artificially increase annual returns by several percentage points.
At a global level, indexes were also market-cap-weighted. But as the Japanese bubble demonstrated, GDP-weighting might be much closer to reality