Next steps in indexation

Investment indices have been around for a very long time. The first equity index was created in 1884 by Charles Dow to indicate the performance of a portfolio containing transportation stocks.  In 1896 he created the more well-known industrials index which is known today as the Dow Jones Industrial Average. These indices are constructed by owning a single share of each company that was included in the index. While simple in their design these indices were important as for the first time they gave investors a sense of “the market”. The concept of which would play a key role in development of future investment theory and strategies.

Fast forward to today and a recent survey[1] by the Index Industry Association estimates that its members calculate over 3.2 million indices across asset classes, geographies and investment strategies. Indexing has certainly come a long way since 1884.

What is the key role of an index?

To answer this question we must take a step back and recognise that the investment process of every investor can be thought of as comprising a general three-step process. Starting with the investor’s opportunity set the three steps are:

  1. Security selection – A subset of the securities is chosen from the investor’s opportunity set for inclusion in the portfolio
  2. Portfolio construction – For each selected security selected its portfolio weight is determined
  3. Implementation – Securities are bought/sold until the investor owns the selected securities in the appropriate weights.

On completing these three steps, the investor owns its desired portfolio of securities.

An index is a technology that allows these investment steps to be separated from each other and carried out by different organisations.

Current index technology separates the investment strategy (steps 1 and 2) and implementation (step 3) by providing a mechanism to communicate the selected securities and their weights from the organisation that is designing the investment strategy to the organisation that is undertaking the implementation. 

It can seem a bit overkill calling an index, like the MSCI World or S&P Global BMI, an investment strategy with security selection and portfolio construction steps. However, even such simple and uncontroversial strategies have a number of design choices embedded in them. For example, should the strategy include emerging market stocks or small caps? Is Korea an emerging market or a developed market? How much liquidity is required for a stock to be eligible? Are company size cut-offs done by country, region or on a global basis?

When we then consider using indices as a means to invest in strategies that target factors or include optimisation procedures the role of the index as the communication mechanism between those designing/running a quantitative investment strategy and those implementing the trading becomes clear. Indeed, most quantitative asset management processes include a moment where the portfolio management team communicates a model portfolio of securities and weights to the trading team. In that moment, they have created an index, albeit an internal one.

Having established that the index as we know it today is a technology for separating the investment strategy from the implementation we can think about where this technology might be deployed in the future.

Are discretionary indices the next step?

Often investors think indices must be rules-based quantitative investment strategies. While this is the perceived status quo, it is simply not the case.

Firstly, let us recognise that even if this was the case an index could be created from a rules-based quantitative strategy that is arbitrarily complex. For example, an investment strategy based on a deep-learning neural network that uses price and fundamental data to select securities and determine their weights can be delivered to investors via an index for implementation.

With the only requirement to make an index being a set of securities and their weights there is nothing to stop those securities and weights being determined by an individual investor’s discretionary judgement. Some would argue that a set of security weights determined by an investor’s judgement is less complicated than the example given previously.

An index where a portfolio manager sets the securities and weights at market close each day and those positions are converted into an index to be tracked the following day is entirely possible given current indexing technology.

All that is being proposed is the separation of determining which stocks to own from the trading of those securities. In fact, given current technology there is no reason a portfolio manager could not provide its portfolio in near real-time to investors via an index that is supplied intra-day.

Potential benefits to asset owners

Over time asset owners have moved away from employing a few asset managers to manage large multi-asset portfolio allocations to using many asset managers. Each manages a small part of the asset owner’s overall portfolio and each brings greater specialist knowledge and insights into those markets. This potential gain from specialisation is offset by the potential reduction is economies of scale. Examples include trading and operations that are now undertaken by many managers, and lost trade-crossing abilities. Two managers buying and selling the same stock or bond at the same time only creates losses for the asset owner. When the dust settles it still owns the stock or bond but has paid transaction costs.

Asset owners also take responsibility for the strategic asset allocation of the portfolio as the asset managers only manage their niche allocation. The tools available to the asset owner are buying/selling asset manager funds which are a very coarse approach to manage the overall portfolio.

A change in the status quo could be that all asset managers (discretionary and/or quantitative) deliver their investment insights through indices. This would allow asset owners to regain the benefits from economies of scale where possible while continuing to benefit from the unique insights of asset managers’ security selection and portfolio construction.

With asset owners controlling the implementation, they can manage the portfolio as a single portfolio rather than a collection of independent portfolios. This would benefit a portfolio that includes long and short positions. Suppose an asset owner has a large long-only equity allocation and a smaller allocation to an equity long/short manager. Run as a single portfolio there is an obvious saving from not paying short-interest on the short positions by first selling those stocks from the long-only allocation.

From a sustainability perspective asset owners would also exert greater influence on the assets they own (since they would directly own the assets themselves) and could implement portfolio level overrides to ensure their sustainability objectives are achieved.

In time, some asset owners may wish to take over portfolio construction as well. By receiving security selection from asset managers via indices an asset owner could then manage their assets as one portfolio, scaling positions as required or adjusting exposures in one part of a portfolio to account for exposure in another. This would create a system where asset managers focus on what they do best selecting securities while asset owners focus on managing the total portfolio to best achieve their goals.

By the way, discretionary indices already exist

As a final thought, discretionary indices are not a new idea. Many people are surprised to learn that the constituents of the S&P 500 index are not the 500 largest US stocks. In fact the constituents are selected by an investment committee.

With $2.9 trillion[2] already tracking this discretionary index maybe this idea isn’t as far-fetched as it might seem….