Almost forty years after the advent of the first index -based investment fund, the segment continues to pilfer assets from active managers through low-cost structure and product innovation. In the beginning, the index investing forefathers: Bogle, Grantham, et. al. probably didn’t have the clairvoyance to envision exactly what their invention would mean for the average investor decades later. However, I can comfortably state that index-based investment methodologies have done more for retail investors than any other financial industry modernization.
All at once, indexing solved the complicated puzzle of diversification, comprehension, and risk management through the ownership of a single investment. Furthermore, it has allowed countless companies to access capital and create jobs at the hands of small and large investors alike, thereby kicking the U.S. economic engine into high gear. Fast forward to today, and their ease of use is beloved by the most sophisticated day traders and simple long term buy-and-holders on a global scale.
In hindsight, it is easy to understand the events that led to the success of index investing. However, it begs the question: What effect has it had on Wall Street and how have investment managers had to adapt to prove their worth?
To understand the impact of what such a righteous movement has done to active investment managers, one only needs to examine a fund’s benchmark. Active managers are now a slave to them, since both institutional and individual investors have the unique ability to constantly evaluate a manager’s worth relative to what they could achieve by owning a passively managed ETF or mutual fund. It has driven many active managers to the fringe of capital market opportunity, seeking esoteric, or thinly offered securities for the chance of outperformance. Statistically speaking, some have found their niche and have offered consistent index-beating returns, but on a broader scale, most have languished.
So as we enter the next generation of index investing, has the surface merely been scratched, or has it been marred beyond recognition?
I think we can all agree that the financial machine is always turning, and eager investors remain hungry for substantial returns. That equation alone will keep index creators eager to discover new ways to add value. In addition, it will drive ETF and mutual fund providers to innovate and bring only the best new products to market in the most expedient manner.
In my opinion, the products that continue to prove their worth as useful tools are tactfully formulated industry-group indexes, with no more than 20-30 stocks. It fosters the comingling of core and strategic investments, and enables advisors to overweight a specific cross section of stocks within a much broader index. A clear benefit in today’s market is being able to access emerging pockets of growth such as the First Trust NASDAQ Global Auto Index (CARZ) or the PowerShares NASDAQ Internet Portfolio (PNQI). These ETFs have the capability to transcend what could be referred to as a “stock picking” strategy, where they can adapt dynamically over time while still being able to focus squarely toward a small facet of the market.
Other passively managed strategies that have garnered not only attention, but assets, are condition-based screens that filter out a specific group of stocks that all share a common trait. My favorite examples include low volatility stocks such as the PowerShares S&P 500 Low Volatility Portfolio (SPLV), and more mature dividend stocks that have been screened from the technology universe in the First Trust NASDAQ Technology Dividend Index (TDIV). Both ETFs specifically target groups of investors that want stock exposure, but have a different set of goals than those investing in the broad market.
So as we look forward in time, it’s anyone’s guess as to what will shape the next forty years of index evolution. However, I believe that the basic model of low-cost, diversification, liquidity, and transparency will always be sound in nature. This tried and true formula will likely continue to attract assets for fund sponsors in the years ahead. Investors continue to face an unprecedented amount of uncertainty in the global markets, which will lead to new innovations in risk management and “smart index” strategies that adapt on the fly.
Note: As of this writing, the author did not own any securities listed in this article.
To get more investor insights from Michael Fabian, visit his blog here or click here to download his latest special report, The Opportunistic Approach to Growth Investing.