A Primer On Defining Indexing Methodologies

Indexing used to be simple. In the old days, a representative sample of securities was rolled into a portfolio, weighted by the respective market values, and left to drift with the market’s tide. This methodology—market cap indexing—is still used, of course. In fact, most of the planet’s assets linked to indexing reside under this conceptual framework. But it has plenty of competition these days. The challenge is figuring out which indexing methodology will be superior, given a particular set of investor expectations, goals, risk tolerance, etc. Before you can even begin to answer, however, you need a clear understanding of what’s on the menu. Where to start? A new research note from the folks at 1741 Asset Management sorts out the basics: “Alternative Beta: Catergorisation of Indices — Do All Roads Lead to Rome?”

The road to Rome is littered with dark alleys and potholes, but if there’s any hope of reaching your destination you need a solid understanding of the available options. Reviewing the various index-design choices is crucial, the paper reminds, for one rather obvious reason: The different indexing rules can lead to different expected return and risk results, particularly over the short term. The good news is that virtually all the primary indexing methodologies fall into one or more of five buckets:

Beta 1: Price-focused beta
Market-cap weighted

Beta 2: Price-agnostic beta
Equal weighted

Beta 3: Fundamental-focused beta
Assets weighted by fundamental criteria, such as book value, sales, etc.

Beta 4: Risk-focused beta

Assets weighted by optimizing and/or minimizing “risk”, such as volatility

Beta 5: Return-focused beta
Assets weighted based on return expectations

The real work, of course, is deciding how to choose from the list above. One possibility is to not even try. In theory, equal weighting all five methodologies has appeal if we’re unsure of how to identify a superior indexing process. But that’s impractical. The idea of owning five index funds for each slice of an asset allocation plan means that the rebalancing process will incur substantially higher transaction and tax costs. That’s a non-starter–indexing is supposed to be tax and cost efficient.

That leaves us with the task of evaluating the strategy choices with an eye on choosing the one or two that best suits our investment goals. But that may not be so easy. Each of the beta replication methods above has a set of pros and cons, which can vary across asset classes. As a result, different investors with different goals and circumstances may come to difference qualitative and quantitative conclusions.

Some of the details about the indexing rules are well known. For example, the only truly passive indexing process is the market-cap design, which implies that expenses for this strategy will be the lowest compared with the other four choices. But there’s a sea of debate about whether market cap indexing will deliver superior return and/or risk results compared with the competition. In other words, does the simplicity and lower cost of market cap indexing come at the price of lower return expectations and/or a higher risk?

The short answer: it’s hard to generalize. Beyond the necessary work of dissecting each indexing strategy and understanding how it works, there are other variables to consider for choosing one over another. Time horizon, for instance, may alter the results. What’s expected to be an ideal indexing strategy under one set of assumptions may not hold up under another.

Ultimately, deciding if the new indexing strategies represent progress depends on crunching the numbers. As the 1741 Asset Management authors explain:

Rather than focusing on semantics, more emphasis should be put on scrutinising the underlying characteristics of these indices. For instance, do the indices provide a targeted and sustainable exposure to common risk factors – such as fundamental indicators or risk measures – that would allow for a characterization of the various indexing methods along different dimensions? Are the beta sources distinctive enough to provide for a diversified pool of passive strategies? Finding the answers to these questions is not only an academic exercise, but of uttermost importance for practitioners. A deep understanding of the distinct qualities of the various indices may help investors to better assess how and when to diversify an existing portfolio with what alternative indices.

The paper offers a good start on defining the basic indexing strategies and reviewing how they compare on a quantitative basis. Still, there’s much more to do. The bottom line: choosing an index fund, or a series of funds to round out an asset allocation, is getting complicated.

There’s a certain amount of irony here. Indexing, after all, was invented in part to simplify investing. But the finance industry isn’t prone to letting simplicity linger (or letting the lowest-cost investment products dominate). Yes, adding nuance to the money game can help, but not always.

This post was originally published at The Capital Spectator and is reproduced here with permission.