A 360-Degree View of Indexing

Indexing is on the rise and spread across all asset classes.

Demand for the passive strategy of indexing is expected to be anything but passive in the years to come, as many institutional and individual investors are taking a fresh look at their views on risk, investment costs and market returns. That was the message from a panel at CME Group's recent Global Financial Leadership Conference in Florida.

"I don't think we've gone as far as we can go with indexing," says Dr. David Blitzer, Standard & Poor's managing director and chairman of the company's Index Committee. "When I first started working in indices, somebody said to me, 'What are you going to do when everything in the world is indexed?' I think human greed, with the idea you can beat the market, is even more eternal than indexing. But I think we will continue to see expansion. We will see it in more and more asset classes."

Demand for index products has gone up due to their ability to produce attractive returns without the investment costs of active management. Economic, legislative and environmental events also will drive indexing growth, says Jamie Farmer, senior director, global index operations and head of exchange relationships at Dow Jones Indexes. "Think about changes in tax law which led to the dividend-weighted index, which was the precursor for fundamentally weighted indexes," he says. "The growth of petrodollars, and really the growth of the Gulf region, has given rise to Islamic finance as an area for indexes as well."

The expansion of indexing is potentially huge, according to the panelists. They expect to see index investments go well beyond underlying stocks and securities to commodities and to fledgling environmental markets that trade rights for industrial pollution, also known as the carbon markets. To keep up with this growing demand for index investments, CME Group offers futures and options on more than 40 U.S. and international indexes.

THE MOVE TOWARD INDEXED ETFs

The session was moderated by Burton Malkiel,, professor of economics at Princeton University and author of one of the most widely read books on individual investing, A Random Walk Down Wall Street. Malkiel notes that his support of indexed exchange-traded funds (ETFs) puts him at odds with Vanguard's John Bogle, "whom I agree with 95 percent of the time." Malkiel paraphrases Bogle's argument, saying, "Why would anybody want to buy the market at 11:15 in the morning and then sell it at 2:15 in the afternoon?"

John Jacobs, executive vice president of NASDAQ financial products and its chief marketing officer, agrees with Malkiel. "The discussion that I've had with Jack on the same topic is that he's throwing out the entire baby with the bathwater," he says, adding, "There are a lot of people buying them, holding them, and getting the benefits of index investing at a lower expense ratio with a good tax benefit over time."

Adds Farmer, Europe is a "nascent" and growing market for ETFs: "The obvious trend is that it's going to keep growing and growing and getting more and more penetration."

Blitzer points out that as industry fortunes wax and wane, there also are possibilities for new indexed ETFs: "It may not quite sound like indexing, but somebody comes along and says, 'We're looking at the housing market and so forth. By next spring, I'm going to want to have a big position in homebuilders' stocks.' They go off and research all of them and they find an ETF focused on homebuilders. You can repeat the same story industry after industry, investing style after investing style. They get the efficiencies, they get diversification within the class which represent some of the benefits of indexing. Maybe they won't do as well as if they bought the S&P 500 and put it away forever, but they'll at least have a little bit more entertainment out of it."

The index model – whether in mutual funds or ETFs – will lend itself to more diverse retirement products in the future. "At Dow Jones we actually publish a variety of series of indexes just for that purpose," says Farmer. "There's been recent legislation that allows products of this sort tied to target-date indexes or hard-to-blend indexes as a default investment option for retirement accounts. And so, the idea of not just equity and fixed income indexes or products – but tying in real estate, tying in commodities, tying in TIPS for an inflation edge, tying in housing – is a very interesting concept. The idea is to emulate the defined benefit space and bring it more into a defined contribution space."

Why Indexing Wins

Burton Malkiel – with Vanguard founder John Bogle – is regarded as one of the fathers of the indexed investment movement. His landmark 1973 book, A Random Walk Down Wall Street, argues that investors cannot consistently outperform market averages over time and, therefore, the investor who achieves market performance at the lowest cost wins.

"Let's say the market gives you 8 percent," Malkiel says. "There are some that have done better, there will be others that have done worse. But that's in the absence of investment costs. Let's now assume 80 basis points of investment costs. What that does is shift the entire distribution to the left... so you only get 7.2 percent."

Indexing is the better approach, Malkiel maintains. "Indexing will miss from time to time, but when it misses you'll be an average performer. When it misses, you don't get into the bottom quartile or the bottom deciles." He adds, "I sometimes say that if the S&P was an athlete, they would probably be testing it for steroids. It's like going out on the golf course and playing every round at par. That's basically what you get with an index fund. It's not mediocre performance; it's better-than-average performance."

Malkiel adds that indexing may actually be more important in the bond market, particularly the markets in short-term bonds and Ginnie Mae securities. "It's only in the high-yield market where there's any reasonable percentage – 21 percent – of active managers who seem to outperform the index. Most of them are very much on the left side of the distribution."

"What I conclude is that indexing works whether you agree with me that markets are reasonably efficient or you don't," concludes Malkiel. "It works in a broad set of markets. It certainly works in the United States, it works in Europe, it works in Japan, it works in emerging markets. Indexing has proved itself very, very well, and I believe the use of index funds, ETFs and so forth will continue to grow."

Back to Fall 2008 Issue Home