Index Managers Require Skills that Benefit Investors Seeking to Avoid Excessive Fees and Under-Performance in Efficient Large Cap Equity Markets
A growing segment of investors desiring exposure to highly efficient equity markets (i.e. large caps in the U.S., Canadian and European markets) see little reason to seek alpha. Instead, they are content with owning cheap beta. For these investors, index managers are not paid to outperform and doing so would constitute a red flag. Rather, index managers are engaged to structure portfolios with a beta of 1, an alpha 0 and a tracking error of 0. That is it.
This article touches on points that investors may want to consider when comparing active to index management. A few required index manager skills are also examined as are three index structures.
Shenanigans of Active Monitoring
Some active managers promote themselves as “consistent pure-alpha generators” when upon close examination their recent performance was achieved via the implemention of a high-beta strategy during a healthy market upswing. Investors that avoid utilizing risk-adjusted performance measures can be easily hoodwinked into believing that the manager is skilled when in fact he is not. Often investors pull wool over their eyes thinking: “so long as the returns are exceptional why bother scrutinizing how they were achieved?” The fact of the matter is that when the tide goes out inept active managers’ lack of skill becomes exposed, and only then do investors classicly shuffle towards the exits. As a general concept, these types of monitoring peeves do not occur with passive index investing.
Indexing Requires Skill
Accurate index tracking requires skill, albeit with far fewer human resources as compared to fundamental active management. Rather, computers are vital as opposed to research teams. Perhaps the greatest attribute required to be a successful index manager is the ability to be highly organized so as to manage many portfolios at once. Great attention to detail, efficient trading techniques and sound portfolio construction are other essential traits that are not easily identifiable as a collective in any one person.
Tracking risk in isolation represents imperfections associated with security weightings. It arises from cash buildup originating from daily cash flows from such vehicles as mutual funds. Also notable are model errors that can result from transaction costs. The required degree of tracking is dependent upon the selected index structure, including the following three:
- Full Replication – required for liquid portfolios such as the S&P 500
- Adjust Positions to Market Cap Weights When Index Changes – accepting of a certain level of tracking differential
- Index Sampling – driven by statistical models and utilized for illiquid securities
Though most investors prefer utilizing some form of a market-based benchmark, they should in fact adopt a risk-based benchmark that is appropriate for their needs. When considering active management, investors should identify managers that are entrepreneurs (i.e. answerable only to their clients) that offer a unique investment strategy within an inefficient universe of securities. Barring that, strong consideration for indexing should be investigated over pre-determined intervals – say every two years – as part of healthy self-examination process.
Essays in Manager Selection, “Chapter 5: Setting Weights for Active and Index Managers”, Scott D. Stewart, PhD, CFA, Research Foundation of CFA Institute. © 2013 CFA Institute. All rights reserved.Version PDF