The air was so thick with smoke created by the marketing presentations from active fund managers that I found it difficult to breathe while attending the 14th annual Super Bowl of Indexing conference held in Phoenix this month. Yes, I did say active managers presenting at an indexing conference.
Perhaps you have not heard: Active management is now indexing, at least according to the fund firms that are spending millions in marketing dollars trying to convince you that it is. The line-up of newfangled index funds and ETFs that has been launched in recent years is not your traditional low-cost, benchmark-index variety that we all know and love. Rather, these are
heavy duty "beat the market" active management strategies, complete with high fees and high turnover.
Here's the key: The Securities and Exchange Commission allows these products to be called index funds because the companies follow a published "rules-based method" for managing portfolios. Simply put, as long as a computer, rather than an individual or an investment committee, is picking stocks, bonds and commodities, the SEC says it is OK to call it index investing. In reality, these structured portfolios have no resemblance to the true spirit of low-cost passive indexing that Jack Bogle created in the mid-1970s when he formed the Vanguard Group of mutual funds. (Learn more about John Bogle in the Greatest Investors Tutorial.)
Indexing used to be a simple idea. It meant putting your money into a broad stock or bond market tracking fund that charged very low fees and earned you a fair share of the market's return. Traditional benchmarks that index funds followed, such as the Russell 3000 and the Barclays Aggregate Bond indexes, select securities passively and weight those securities based on capitalization. That method best reflects a market's dollar value and represents the investible universe from which all investors choose securities. Index funds and market based ETFs were marvelous advancements because they are a perfect way for investors to access basic asset class exposures at low cost. This simple idea propelled Vanguard to over $1 trillion dollars in assets.
Well, there is nothing like a cool trillion in assets to attract the spinsters from Wall Street. After decades of fighting a losing battle against traditional indexing, the active management crowd has finally figured out of a way to get their hands on at least part of the money. The tactic? "If you can't beat 'em, join 'em"--or at least make it appear as if you are joining them.
Today, the spin from the active fund managers is that they are the indexers. In fact, the active side claims they are better indexers than the likes of Vanguard and other more traditional indexing firms. The active side claims their superior intellect helps them create new indexes that beat the pants off those stodgy old "last century" indexes followed by the old guard. Of course, just as with all other active management strategies, the fees built into products that follow these new indexes are many times higher than those of the traditional index funds that Jack Bogle believes in.
You may have heard the names of these new-fangled indexing techniques. They include fundamental indexing, enhanced indexing, quantitative indexing, leveraged indexing and a variety of other strategies that have placed the word "indexing" after whatever active strategy they are following. The purpose in doing this is to make you think that these new indexes are superior, and thus to divert money destined for traditional index funds into the more expensive products. This marketing gimmick reminds me of the dot-com bubble when companies tried to boost their stock prices by adding ".com" to their names. After some success, we all realized that Dog Food, Inc. was not going to be a better run company just because it changed its name to DogFood.com.
I dream of the day the SEC forces these new-fangled index providers to put the words "structured product" in front of the word index, because that is what these things really are. However, since my small voice is not likely to change the SEC policy, I think that we in the public should simply start calling them Structured Products Index funds, or SPINdex for short. SPINdex is a fitting acronym because it's an accurate description of what the public is getting with these products.
When SPINdex products first came out in 2003, the fund companies were allowed to compare the hypothetical index return to the return of a standard benchmark. Of course, that meant every new SPINdex handily outperformed because it is easy to beat an index based on 20/20 hindsight, but there is no guarantee those trading rules will lead to superior performance in the future. This is no different than a job-seeker fabricating a resume showing superior skill in a job they never did. Fortunately, the SEC has now banned the seedy marketing practice of promoting make-believe performance, so you should not see any more hypothetical performance numbers.
There are rare cases when an actively management index actually does outperform a market benchmark in real time. This outperformance is labeled as "Alpha" by the fund company. Of course, as every student of active investing knows, Alpha--a net return in excess of the market risk of a portfolio--is fleeting. The strategy that creates Alpha today may not be the one with Alpha tomorrow. So, how does a SPINdexing company deal with this? Well, since we are talking indexing and not a live active manager person, the sellers of these SPINdex products claim that these indexes are producing ‘Beta', not Alpha. Beta means the index strategy is isolating some previously unknown risk in the marketplace and capitalizing on that risk in the form of higher returns.
Wow! These folks really are smart! Please find me an oxygen bottle before I choke with enthusiasm.
OK, back to reality. What is the fallacy behind SPINdexing?
First, there is no guaranteed Alpha from any active management strategy, so there can be no Beta in a SPINdex. In his classical paper, The Arithmetic of Active Management, Stanford emeritus professor and Noble Laureate William F. Sharpe clearly points out that active managers cannot beat the market because in aggregate all investors are the market less fees. In other words, the mass of investors can only earn market beta less investment costs. A commoditization of Alpha into Beta must be a myth because there cannot be net Alpha in every one of the hundreds of SPINdex strategies available in mutual funds and ETFs.
Second, trying to pick the SPINdex strategy that may actually produce a newly found Beta is futile. In the rare case a computer model did beat the market, how long should we expect this free lunch to last? The SEC requires all ETFs to disclose holdings on a daily basis. Consequently, professional traders would arbitrage away this Alpha long before you or I ever had a chance to invest in it as Beta. If the outperformance continues, then there would be a mad rush to launch "copycat" funds by competitors that would marginalized away this advantage in a very short time. Experienced indexers know that there is a free lunch on Wall Street. Unfortunately, it is individual investors who like you and me who are expected to serve the free meal. Don't be part of that.
Indexing started out as a great idea, and it still is. Very low-cost, market-based index funds and ETFs help people meet their financial liabilities. Unfortunately, indexing pollution has run amok. And while there have been some interesting advances in index construction that have actually helped portfolios, those innovations are overwhelmed by the SPINdexers who have a different agenda. I believe this truth about indexing needs to be repeated loud and often. So, whenever you can and wherever you are, tell people to Index--Don't SPINdex.