The Story of Indexing

Since nearly every media outlet on the planet reported the news, you probably already know that the Dow Jones Industrial Average topped 20,000 for the first time on January 25, 2017. But when a popular index like the Dow is on a tear, up or down, what does it really mean to you and your investments? Let's explore some of the ins and outs of indexes and the index funds that track them. 

What Is an Index?

Let’s set the stage with some definitions. 

An index tracks the returns generated by a basket of securities that an indexer has put together to represent (“proxy”) a particular swath of the market.

Some of the familiar names among today’s index providers include the S&P Dow Jones, MSCI, FTSE Russell and Wilshire. It’s perhaps interesting to note that some of the current index providers started out as separate entities – such as the S&P and the Dow, and FTSE and Russell – only to consolidate over time. In any case, here are some of the world’s most familiar indexes (with “familiar” defined by where you’re at):

• S&P 500, Nasdaq Composite, and Dow (U.S.)

• S&P/TSX Composite Index (Canada)

• FTSE 100 (U.K.)

• MSCI EAFE (Europe, Australasia and the Far East)

• Nikkei and TOPIX (Japan/Tokyo)

• CSI 300 (China)

• HSI (Hong Kong) 

• KOSPI (Korea

• ASX 200 (Australia)

…and so on

Why Do We Have Indexes?

Early on, indexes were designed to offer a rough idea of how a market segment and its underlying economy were faring. They also helped investors compare their own investment performance to that market. So, for example, if you had invested in a handful of U.S. stocks, how did your particular picks perform compared to an index meant to track the average returns of U.S. stocks? Had you “beat the market”? 

Then, in 1976, Vanguard founder John Bogle launched the first publicly available mutual fund specifically designed to simply copy-cat an index. The thought was, instead of spending time, money and energy trying to outperform a market’s average, why not just earn the returns that market has to offer (reduced by relatively modest fund expenses)? The now familiar Vanguard 500 Index Fund was born … along with index fund investing in general. 

There are some practical challenges that prevent an index from perfectly replicating the market it’s meant to represent. We’ll discuss these in future segments. But for now, the point is that indexes have served investors across the decades for two primary purposes: 

1. Benchmarking: A well-built index should provide an approximate benchmark against which to compare your own investment performance … if you ensure it’s a relatively fair, apples-to-apples comparison, and if you remain aware of some of the ways the comparison still may not be perfectly appropriate. 

2. Investing: Index funds that replicate indexes allow you to indirectly invest in the same holdings that an index contains, with the intent of earning what the index earns, net of fees. 

Indexes Are NOT Predictive

There is also at least one way indexes should NOT be used, even though they often are: 

Index milestones (such as “Dow 20,000”) do NOT foretell whether it’s a good or bad time to buy, hold or sell your own investments.

Indexes don’t tell us whether the markets they are tracking or the components they are using to do so are over- or under-priced, or otherwise ripe for buying or selling. Attempting to use current index values as a way to time your entry into or exit from a market does not, and should not replace understanding how to best reflect your unique investment goals and risk tolerances in an evidence-based investment strategy. 

In fact, market-timing of any sort is expected to detract from your ability to build wealth as a long-term investor, which calls for two key disciplines: 

1. Building a cost-effective, globally diversified portfolio that exposes you to the expected returns you’d like to receive while minimizing the risks involved

2. Sticking with that portfolio over the long run, regardless of arbitrary milestones that an index or other market measures may achieve along the way 

As blogger and adviser Bill Huber observed the day after the Dow first broke 20,000: “Sensationalism of events like these [Dow 20,000] has the ability to trigger our animal spirits or our worst fears if we don’t have a long-term investment plan to keep them in check.”

So first and foremost, have you got those personalized plans in place? Have you constructed a sensible investment portfolio you can adhere to over time to reflect your plans? If not, you may want to make that a top priority. Next, we’ll explore some of the mechanics that go into indexing, to help put them into the context of your greater investment management.

As we covered in our last piece, indexes have their uses. They can roughly gauge the mood of a market and its participants. If you’ve got an investment strategy that’s designed to capture that market, you can see how your strategy is doing in comparison … again, roughly. You can also invest in an index fund that tracks an index that tracks that market. 

This may help explain why everyone seems to be forever watching, analyzing and talking about the most popular indexes and their every move. But you may still have questions about what they are and how they really work. For example, when the Dow Jones Industrial Average (the Dow) exceeded 20,000 points last January, what were those points even measuring? 

An index’s total points represent a relative value for the market it is tracking, calculated by continually assessing that market’s “average” performance.

If that’s a little too technical for your tastes, think of it this way: Checking an index at any given time is like dipping your toe in the water to see how the ocean is doing. You may have good reasons to do that toe-check, but as with any approximation, be careful to not misinterpret what you’re measuring. Otherwise, you may succumb to misperceptions like: “The Dow is so high, it must be in for a fall. I’d better get out.” 

With that in mind, when it comes to index points, we’d like to make a few points of our own. 

Indexes Are Often Arbitrary 

It helps to recognize how popular indexes become popular to begin with. In our free markets, competitive forces are free to introduce new and different structures, to see how they fly. In the same way that the markets “decided” that the iPhone would prevail over the Blackberry, popular appeal is effectively how the world accepts or rejects one index over another. Sometimes the best index wins and becomes an accepted reference. Sometimes not. 

Measurements Vary

Different indexes can be structured very differently. That’s why the Dow recently topped 20,000, while the S&P 500 is hovering in the 2,000s, even though both are often used to gauge the same U.S. stock market. The Dow arrives at its overall average by adding up the price-weighted prices of the 30 securities it’s tracking and dividing the total by a proprietary “Dow divisor.” The S&P 500 also takes the sum of the approximately 500 securities it’s tracking … but weighted by market cap and divided by its own proprietary divisor. 

With mysterious divisors, terms like “price-weighted” and “market cap,” and additional details we won’t go into here, this probably still doesn’t tell you exactly what index points are. 

Think of index points as being like thermometer degrees. Most of us can’t explain exactly how a degree is calculated, but we know hot from cold. We also know that Fahrenheit and Celsius both tell us what the temperature is, in different ways.

Same thing with indexes. You can’t directly compare an S&P 500 point to a Dow point; it doesn’t compute. Moreover, neither index adjusts for inflation. So, while index values offer a relative sense of how “hot” or “cold” a market is feeling at the moment, they can’t necessarily tell you whether a market is too hot or too cold, or help you precisely predict when it’s time to buy or sell into or out of them. The “compared to what?” factor is missing from the equation. This brings us to our third point …

Models Are Approximate

There’s an important difference between hard sciences like thermodynamics and market measures like indexes. On a thermometer, a degree is a degree. With market indexes, those points are based on an approximation of actual market performance – in other words, on a model.

A model is a fake copy of reality, with some copies rendered considerably better than others. Here’s what Nobel Laureate Eugene Fama has said about them: “No model is ever strictly true. The real criterion should be: Do I know more about markets when I’m finished than I did when I started?”

According to Professor Fama’s description of a model, indexes have long served as handy proxies to help us explore what is going on in particular slices of our capital markets. But, they also can do damage to your investment experience if you misinterpret what they mean. 

For now, remember this: An index’s popular appeal is the result of often-arbitrary group consensus that can reflect both rational reasoning and random behavioral bias. Structures vary, and accuracy is (at best) approximate. Even the most familiar indexes can contain some surprising structural secrets.  

Market indexes.

You read about them all the time, such as when the Dow Jones Industrial Average (the Dow) topped 20,000 points in early 2017 … and then broke 21,000 just over a month later. In our last piece, we explored what those points actually measure, which isn’t always what you might guess. Today, we’ll take a closer look at the mechanics of indexing, to gain a better understanding of why they do, what they do. 

The Birth of Indexing 

When you hear the term “stock index,” you’re in good company if the first thing that comes to mind is the S&P 500; some of the world’s largest index funds are named after it. We’ll talk more about index investing in our next piece, but we’ll note here that, despite its familiarity, the S&P 500 is a babe in the woods compared to the world’s first index. That honor goes to the Dow. 

The Grand Old Dow

As described in “Capital Ideas” by Peter Bernstein: “The first Dow Jones Average appeared in the Afternoon News Letter on July 3, 1884. It consisted of the closing prices of eleven companies: nine railroads and two industrials. [Charles] Dow’s idea was to provide an overall measure of the performance of active companies, at a time when an average day’s activity on the New York Stock Exchange was about 250,000 shares.”

Eleven companies, nine of them railroads, wouldn’t make for much of a market proxy these days! And yet the Dow still only tracks 30 stocks, as it has since 1928. Plus, it still uses mostly the same methods for tracking them. As expressed by James Mackintosh, a senior market columnist for The Wall Street Journal (the effective birthplace of the Dow): “It’s time to ditch the Dow. After 120 years, the venerable Dow Jones Industrial Average is an embarrassing anachronism, abandoned by professionals and beloved only by a media that mostly knows no better. It needs to be updated or, better, replaced.”

And yet, despite its flaws, the Dow persists. Markets are made of people, and people can be sentimental about their past. More pragmatically, the Dow serves as a time capsule of sorts, offering historical perspective no other index can match. It’s also just plain familiar. As its parent company the S&P Dow Jones Indices says, “It is understandable to most people.” 

How Do Indexes Get Built? 

What about all those other indexes? New ones come along whenever an indexer devises a supposedly better mousetrap for tracking market performance. If enough participants accept the new method, an index is born. 

That’s our free markets at work, and it sounds simple enough. But if we take a closer look at the various ways indexers track their slices of the market, what may seem clear at a glance is often seething with complexities just under the surface. Here are some (not all!) of the ways various indexes are sliced and diced. 

Which Weighting? 

How much weight should an index give to each of its holdings? For example, in the S&P 500, should the returns delivered by Emerson Electric Company hold the same significance as those from Apple Inc.? 

The Dow is price-weighted, giving each company more or less weight based on its higher or lower share price. As Mackintosh explained, “share prices are arbitrary, as they depend on how many shares are issued; some companies have very high prices, which give them more influence on the Dow, even though they may be less valuable overall.”

Market-cap weighting is the most common weighting used by the most familiar indexes around the globe. It factors in outstanding shares as well as current share price to give more weight to the bigger players and less to the smaller fry. 

Some indexes are equal-weighted, giving each holding, large or small, equal importance in the final tally. For example, there’s an equal-weighted version of the S&P 500, in which each company is weighted at 0.2% of the index total, rebalanced quarterly. 

There are many other variations on these themes. The point is, indexes using different weightings can reach significantly different conclusions about the performance of the same market slice. 

Widely Inclusive or Highly Representative?  

How many individual securities does an index need to track to correctly reflect its target market? 

As we mentioned above, the Dow uses 30 securities to represent thousands of publicly traded U.S. stocks. A throw-back to simpler times, it’s unlikely you’ll see other popular indexes built on such modest samples. In its defense, the Dow favors stocks that are heavily and frequently traded, so prices are timely and real … at least for the 30 stocks it’s tracking. 

At the other end of the spectrum, the Wilshire 5000 Total Market Index “contains all U.S.-headquartered equity securities with readily available price data.” 

The S&P 500 falls somewhere in between, tracking around (not always precisely) 500 publicly traded U.S. securities.

Tracking a Narrow Slice or a Mixed Bag?

What makes up “a market,” anyway? Consider these possibilities: 

If an index is tracking the U.S. market, should that include real estate companies too? 

If its make-up tends to include a heavier allocation to, say, value versus growth stocks, how does that influence its relative results … and is it a deliberate or accidental tilt? 

Is an index broadly covering diverse sectors (such as representative industries or regions) or is its focus intentionally concentrated? 

If it’s tracking bonds, are they corporate and municipal bonds, or just one or the other? 

The Use and Abuse of Indexing

How well do you really know what your index is up to? Remember, in Part I of this series (Issue 4), we described how every index is a model – imperfect by definition. How might each index’s inevitable idiosyncrasies be influencing the accuracy of its outcomes? 

We’ve just touched on a few of the questions an indexer must address. Like the proverbial onion, many more layers could be peeled away and, the deeper you go, the finer the nuances become.

One practical conclusion is that some indexes are much easier to translate into investable index funds than others. In addition, some lend themselves better than others to a sound, evidence-based investment strategy. In fact, indexes often may not be the ideal solution for that higher goal to begin with.

Unintended Outcomes

Legend has it, a pharmacist named John Pemberton was searching for a headache cure when he tried blending Coca leaves with Cola nuts. Who knew his recipe was destined to become such a smashing success, even if Coca-Cola® never did become the medicine Pemberton had in mind?

In similar vein, when Charles Dow launched the Dow Jones Industrial Average (the Dow), his aim was to better assess stock prices and market trends, hoping to determine when the market’s tides had turned by measuring the equivalent of its incoming and outgoing “waves.” He chose industrials (mostly railroads) because, as he proposed in 1882, “The industrial market is destined to be the great speculative market of the United States.” 

While the actively minded Dow never did achieve market-timing clairvoyance (and neither has anyone else we’re aware of), he did devise the world’s first index. We’d like to think his creation turned into something even greater than what he’d intended – especially when Vanguard founder John Bogle and other pioneers leveraged Dow’s early work to create among the most passive ways to invest in today’s markets: the index fund. 

Bogle launched the first publicly available index fund in 1976. Initially dismissed by many as “Bogle’s folly,” its modern-day rendition, the Vanguard 500 Index Fund, remains among the most familiar funds of any type. 

Index Investing Is Born

In defense of Dow’s quest to forecast market movements, it’s worth remembering that his was a world in which electronic ticker tape was the latest technology, there were no open-ended mutual funds or fee-only financial advisors, and safeguards and regulations were few and far between. Essentially, speculating was the only way one could invest in late-nineteenth century markets. 

Compared to actively managed funds that seek to “beat” the market by engaging in these now-outdated speculative strategies, passively managed index funds offer a more solid solution for sensibly capturing available market returns. As the name implies, an index fund buys and holds the securities tracked by a particular index, which is seeking to represent the performance of a particular slice of the market. For example, the Vanguard 500 Index Fund tracks the popular S&P 500 Index, which in turn approximately tracks the asset class of U.S. large-company stocks. 

Compared to actively managed solutions, index funds lend themselves well to helping investors more efficiently and effectively target these three pillars of sensible investing: 

Asset allocation – How you allocate your portfolio across various market asset classes plays a far greater role in varying your long-term portfolio performance than does the individual securities you hold. 

Global diversification – Through broad and deep diversification, the sum of your whole risk can actually be lower than its individual parts. 

Cost control – The less you spend implementing a strategy, the more you get to keep. 

Index Investing: Room for Improvement

As we’ve described throughout this series, indexes weren’t specifically devised to be invested in. There’s often a lot going on underneath their seemingly simple structures that can lead to inefficiencies by those trying to retrofit their investment products on top of popular indexes. 

Index Dependence – Whenever an index “reconstitutes” by changing the underlying stocks it is following, any funds tracking that index must change its holdings as well – and relatively quickly if it’s to remain true to its stated goals. In a classic display of supply-and-demand pricing, this can generate a “buy high, sell low” environment as index fund managers hurry to sell stocks that have been removed from the index and buy stocks that have been added. 

Compromised Composition – Asset allocation is based on the premise that particular market asset classes exhibit particular risk and return characteristics over time. That’s why your investment “pie” should be carefully managed to include the right asset class “slices” for your financial goals and risk tolerances. As we described in Part III of this series, if you’re invested in an index fund and you aren’t sure what its underlying index is precisely tracking, you may end up with off-sized pieces of pie. For example, the S&P 500 and the Russell 3000 are both positioned as U.S. stock market indexes, but both also track some real estate. If you don’t factor that into your plans, you can end up with a bigger helping of real estate than you had in mind. 

Introducing Evidence-Based Investing

So, yes, index investing has its advantages … It also has inherent challenges. No wonder academically minded innovators from around the globe soon sought to improve on index investing’s best traits and minimize its weaknesses. In fact, many of these thought leaders were the same early adapters who introduced index fund investing to begin with. Building on index investing, they devised evidence-based investment funds, to offer several more advantages: 

Index-independence – Instead of tracking an index that tracks an asset class … why not just directly capture the asset class itself as effectively as possible? Evidence-based fund managers have freed themselves from tracking popular indexes by establishing their own parameters for cost-effectively investing in most of the securities within the asset classes being targeted. This reduces the need to place unnecessary trades at inopportune times simply to track an index. It also allows more patient trading strategies and scales of economy to achieve better pricing.

Improved Concentration – Untethering themselves from popular indexes also enables evidence-based fund managers to more aggressively pursue targeted risk factors; for example, an evidence-based small-cap value fund often has more flexibility to hold smaller and more value-tilted holdings than a comparable index fund. This provides more refined control for building your personal investment portfolio according to your unique risk/return goals. 

Focusing on Innovative Evidence – Evidence-based investing shifts the emphasis from tracking an index, to continually improving our understanding of the market factors that contribute to the returns we are seeking. By building portfolios using fund managers who apply this same evidence to their funds, you can make best use of existing academic insights, while efficiently incorporating credible new ones as they emerge. 

An Index Overview, Revisited

From describing an index’s basic functions, to exploring some of the intricacies of their construction, we’ve covered a lot of ground in this four-part series on indexing. To recap, indexes can help us explore what is going on in particular slices of our capital markets. In the right context, they also can help you compare your own investment performance against a common benchmark. Last but not least, you can invest in funds that track particular indexes. 

Equally important, remember that indexes do not help us forecast what to expect next in the markets, nor do high-water markets such as “Dow 20,000” foretell whether it’s a good or bad time to buy, hold or sell your own market holdings. And, while low-cost, well-managed index funds may still play a role in your overall investment portfolio, it’s worth ensuring that you select them when they are the best fit for your evidence-based investment strategy, not simply because they are a popular choice at the time. 

Doubt is not a pleasant condition, but certainty is an absurd one.

—Voltaire

“The market hates uncertainty” has been a common enough saying in recent years, but how logical is it? There are many different aspects to uncertainty, some that can be measured and some that cannot. Uncertainty is an unchangeable condition of existence. As individuals, we can feel more or less uncertain, but that is a distinctly human phenomenon. Rather than ebbing and flowing with investor sentiment, uncertainty is an inherent and ever-present part of investing in markets. Any investment that has an expected return above the prevailing “risk-free rate” (think T-Bills for US investors) involves trading off certainty for a potentially increased return.

Consider this concept through the lens of stock vs. bond investments. Stocks have higher expected returns than bonds largely because there is more uncertainty about the future state of the world for equity investors than bond investors. Bonds, for the most part, have fixed coupon payments and a maturity date at which principal is expected to be repaid. Stocks have neither. Bonds also sit higher in a company’s capital structure. In the event a firm goes bust, bondholders get paid before stockholders. So, do investors avoid stocks in favor of bonds as a result of this increased uncertainty? Quite the contrary, many investors end up allocating capital to stocks due to their higher expected return. In the end, many investors are often willing to make the tradeoff of bearing some increased uncertainty for potentially higher returns. 

MANAGING EMOTIONS

While the statement “the market hates uncertainty” may not be totally logical, it doesn’t mean it lacks educational value. Thinking about what the statement is expressing allows us to gain insight into the mindset of individuals. The statement attempts to personify the market by ascribing the very real nervousness and fear felt by some investors when volatility increases. It is recognition of the fact that when markets go up and down, many investors struggle to separate their emotions from their investments. It ultimately tells us that for many an investor, regardless of whether markets are reaching new highs or declining, changes in market prices can be a source of anxiety. During these periods, it may not feel like a good time to invest. Only with the benefit of hindsight do we feel as if we know whether any time period was a good one to be invested. Unfortunately, while the past may be prologue, the future will forever remain uncertain.

Staying in Your Seat

In a recent interview, David Booth was asked about what it means to be a long-term investor:

“People often ask the question, ‘How long do I have to wait for an investment strategy to pay off? How long do I have to wait so I’m confident that stocks will have a higher return than money market funds, or have a positive return?’ And my answer is it’s at least one year longer than you’re willing to give. There is no magic number. Risk is always there.”

Part of being able to stay unemotional during periods when it feels like uncertainty has increased is having an appropriate asset allocation that is in line with an investor’s willingness and ability to bear risk. It also helps to remember that, during what feels like good times and bad, one wouldn’t expect to earn a higher return without taking on some form of risk. While a decline in markets may not feel good, having a portfolio you are comfortable with, understanding that uncertainty is part of investing, and sticking to a plan that is agreed upon in advance and reviewed on a regular basis can help keep investors from reacting emotionally. This may ultimately lead to a better investment experience.