Commentary: It's not your father's indexing
August 02, 2013
By Vanguard Chief Investment Officer Tim Buckley
Back in the 1980s, Oldsmobile tried to redefine itself with the slogan "It's not your father's Oldsmobile." They suggested the brand's previous cars were old-fashioned, while its new models were sleek and modern.
Today, certain investment companies are trying to do the same—rebranding various investment strategies as a new kind of indexing. Called alternative indexing, fundamental indexing, and, in some cases, "smart beta"—these terms are being widely used to describe any index considered an alternative to the traditional method, in which indexes are weighted based on the market capitalization of the companies they invest in.
These strategies are nothing new. Vanguard would argue they are more transparent, simplified descendants of active-quantitative strategies that fell out of favor after the quant bust in August 2007, the 2008 financial crisis, and subsequent high-profile missteps by some quantitatively oriented investment managers.
Unlike a market-capitalization-weighted approach, none of these strategies enable you to "own the market." Instead, they will simply either do better than the market, or worse than it. The trick is to find the investment manager or strategy that puts you on the winning side. The risk is ending up a loser relative to the index or suffering a poor outcome given the portfolio's specific exposures. The cost is whether you pay more than had you been in a cap-weighted index fund.
These questions are similar to those faced by investors considering actively managed funds as opposed to index funds, and they suggest that investors should evaluate non-cap-weighted strategies through an "active management lens."
But that's not as easy as it sounds. Many alternative indexing strategies are based on "back-tested" data—performance data that existed before the indexes were publicly available. Our research demonstrates that, on average, back-tested performance appears to fade past the date an index is first published to the public and starts to use live data. We think it's because benchmarks could be chosen based on their attractive performance history. And, of course, past performance is no guarantee of future results.
That said; there's nothing inherently wrong with non-cap-weighted strategies. The search for outperformance has been the age-old objective of traditional active managers. But if this was as simple as writing some rules on a napkin and investing accordingly, we’d expect to see a robust history of outperformance across the board. In reality, we've seen the opposite.
We believe that when you buy an index fund, you expect to own the market. Yet a rules-based, non-cap-weighted strategy doesn't give you that kind of exposure. You are, in fact, betting against the market—or at least some segment of it.
This is an important distinction. It's why alternative indexing, smart beta—or whatever you want to call it—is not your father's indexing. And you probably should take a careful look under the hood before making it yours.
For additional analysis of non-cap-weighted strategies, read our research:
- Joined at the hip: ETF and index development
- Alternative equity approaches to indexing: Buyer be aware
- Alternative bond indexes: Trading one risk factor for others?
- All investing is subject to risk, including the possible loss of the money you invest.
- Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
- Diversification does not ensure a profit or protect against a loss.