The Future of Indexing

Today, indexing might be 20% of total US institutional equity. And now indexing is done on a number of indices like emerging markets, industry groups and other security classes. It is rather surprising that it is not greater. One feature that may have been restraining growth is the agency cover of indexing, which is not as great as with an active manager: more of the responsibility of investment selection may, under some interpretations, reside with the index client than with active managers. Furthermore, if equity markets have an extended decline, indexing may be arrested in its growth.

Indexing lends itself well to being packaged with other services like performance measurement, custody and administration and corporate governance monitoring (see Performance Measurement and Corporate Governance). Thus, the management cost of indexing is often bundled with services customarily offered by large integrated banks.

Indexing is a strategy that has been applied to many different categories of investing. It provides an efficient way for investors to participate in broadly diversified portfolios. Nevertheless, many investors will continue to be attracted to the distinctive investment philosophies and strategies offered by the wide range of actively managed funds (see Active Portfolio Management). A suitable compromise may be to build equity and bond portfolios (or even combine them through a balanced approach) with a core holding in an appropriate index fund. Around that core investment, an investor may select specific actively managed funds that appear likely, in the investor's judgment, to add incremental investment performance over the long run.

Critics on Indexing

Indexing derives originally from the concept of market efficiency (see Market Efficiency). But markets are efficient only if investors study all available information and move prices to reflect the published data. This implies that as the market share of indexers rises, institutions will employ fewer and fewer analysts, the market will become less efficient, and this will give active managers the chance to outperform the index and index managers.

Of course, there will always be actively managed funds that outpace index funds over long periods. But is it luck or skill? Probability indicates that some investment managers may provide exceptional returns over lengthy winning streaks. But there may also be some investment managers with truly outstanding abilities who can earn superior returns over time. The problem in selecting actively managed funds is how to identify in advance those that will be consistently superior over time.

On the surface, all stock index funds should have identical total returns. But they do not because their expenses vary. Expense ratios (the percentage of costs to assets) generally range from 0.2-0.6%. The average for actively managed funds is 1.3%. Since many index funds began only in the past few years, the high-cost ones usually justify themselves by saying there was a significant start-up
expense. And some index managers admit privately that high expenses exist because the funds feel they can get away with it.

Another potential problem with indexing relates to corporate governance. As indexing took off, proxy voting slowly became an issue when the normal tool for expressing dissatisfaction with corporate behavior liquidation of a stock position was unavailable.

Part of the index fund advantage has resulted from being 100% invested in stocks at all times in a bull market buying stocks going up and selling those going down because of companies going in and out of the index. Indeed, this drives up the market as trackers are fully invested and do not allocate assets between equities, bonds and cash. Since most equity funds maintain cash reserves of 5-10% of net assets, they lost ground to index funds in the bull market in stocks during the 1980s and 1990s.

Of course, in periods of market declines, index funds can be expected to have somewhat larger declines than funds maintaining cash reserves. Yet they may convey the illusion of safety. Stock picking may work better in a flat or bear market another justification for active managers.