Index investing is often described as “passive” or “beta” investing. However, one thing that is often looked past is exactly how active the construction process of indexes is in practice. Steve Galbraith used to say when I, and he, was with Morgan Stanley (before he went to manage money with Maverick Capital) that buying the S&P500 meant investing in an actively managed, overvalued, large cap growth fund. This was especially true in the late 1990′s as more and more technology was added to the index.
All About Alpha examines the results of a paper in the January 2008 edition of the Journal, European Financial Management which shows Steve had it right:
In other words, these “selection and exclusion rules” constitute active management (much to the delight, we’re guessing of Fundamental Indexation proponents). In fact, the authors say these rules have an effect remarkable similar to recognized trading strategies “such as momentum, autocorrelation and the limitation of tail risks.”
Result? Better performance during bull markets, worse in bear markets. Color us unsurprised. Indexes have both alpha and beta characteristics.
A core takeaway, risk and return characteristics of indexes have to be assessed. There is no true passive investing and in building your asset allocation the construction of the index, whether invested in through mutual funds and ETF’s, or used as a benchmark, carries tremendous weight.
Read the whole thing.
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