Lately, the topic d'jour in the ETF industry (aside from Vanguard's entrance) has been whether actively-managed indices and the ETF's that track them are viable products. This is a very formidable debate to be had, but I beg the question - are our current indices not already actively managed?
With the popularity of ETF's and its emergence as a competitor to mutual funds and separately managed accounts - the business of indexing has become a big one. Standard and Poor's (a division of McGraw Hill) and many of the exchanges (which are now "for-profit" entities) make money of of leasing out their index to various asset management firms to use in their ETF's. If you are a Barclays or Vanguard, tTo be able to sell an ETF mimicking the S&P 500 or the EAFE you must pay the maker or the index - if you want to advertise that it follows such an index. The introduction of Powershares "Intellidex" indices creates a form of competition that was not there before. If you are Standard and Poors, you now want to make sure that your index outperforms the Powershares Index or else you may lose the monopoly you have on "the market". What is an index such as the S&P but a mutual fund of 500 stocks weighted by market cap (or more specifically, float), with discretion given essentially to sector weightings. The S&P, therefore generates alpha by what sectors it chooses to overweight - which basically determines the stocks that will be included. The weightings of the individual stocks are essentially independent of the entire process. If Standard and Poors wants to go heavier on Energy, they add another oil name, and so on.
It is difficult for S&P to generate that much alpha in their S&P 500 index, but for Barclays to generate alpha for their iShares Biotechnology index, they rely on NASDAQ's Biotechnology Index - very geared towards their top five holdings. According the to NASDAQ website,
The NASDAQ Biotechnology Index contains securities of NASDAQ-listed companies classified according to the Industry Classification Benchmark as either Biotechnology or Pharmaceuticals which also meet other eligibility criteria. The NASDAQ Biotechnology Index is calculated under a modified capitalization-weighted methodology.
So, there is definitely a great deal of discretion over the contents of this index. If this index begins out outperform other biotech indices, Barclays may want to change its index provider from NASDAQ to S&P or someone else - eliminating any royalties that NASDAQ receives as well as the commissions they earn from these stocks being traded on their index through the ETF. It is therefore in their interest to create the best index possible. Is that not active management?
This of course has some interesting implications. First off, Index Providers, who in the past were more interested in presenting an informational product are now tied to an asset management investment product. Therefore they are less inclined to present an accurate representation of the overall market and more inclined with outperforming the market. Since the ETF business now creates even more net inflows into the stocks that they represent, it is a self fulfilling prophecy of sorts, which has implications all to itself. For example if the Fidelity Contrafund was a readily available index to follow, and all of a sudden considered by the general public as the indicator of the markets as well as a benchmark for active managers to follow, the stocks that it owned in the fund would become more valuable. Many passive investors would try to invest alongside the index as well. In reality, William Danoff is concerned (or should be concerned) solely with outperforming his competition - other equity funds or contrarian funds. His investment strategy is to invest in stocks that are contrary to the general market opinion, but at the same time the market opinion is becoming his own - causing his contrarian style benefit from the money flowing into his contrarian ideas. His fund will continue to grow and value of the stocks within it - as his opinion changes and he sells off some holdings for others the market moves with him as well. Therefore the value of his fund goes up and up and up. The belief that his "index" represents the market therefore inflates the value of the shares of his mutual fund, but the divergence between what his fund's holdings and performance and his funds holdings and performance become wildly different. The Contrafund example is of course an extreme one, but illustrates how this divergence between what index providers are concerned with and what the investing public believes to be true can cause the indices that are provided to diverge from the reality of the market that it is supposed to follow.
A secondary impact is on active managers. If you are an Small Cap Value manager, using the S&P Small Cap 600 as your benchmark, you can not compete on price with the S&P, therefore as ETF popularity rises, the reward for following an index falls - since you are likely to get about the same return at more than double the expense ratio - and with tax concerns. Therefore you must take much more risk NOT to mimic your benchmark. This will introduce a greater variability in performance in a Lipper Category. The top Morningstar rating and the bottom Morningstar rating will vary wildly from the average percentile as more managers are out there taking larger tracking error risks. This may cause a huge shakeout and then resurgence in Mutual Fund management as it will create both many more losers and winners alike, with losers losing more and winners winning more. So, ETF's the "mutual-fund killer" of sorts may cause them to become more popular - as investors are searching for that 10 point alpha which now pays to take the risk over what used to "historically outperform active managers".
In addition, large investment banks may begin to create more indices in order to benefit from this boom. In the past, they made money out of selling their in-house funds - which came with a lot of hair on them causing many to be skeptical. Now, creating an index, that is largely thought to be "harmless" and selling it to an asset management company allows them to still get their share of this market as well add some value to the increasingly worthless sell-side research arms. This may be one reason why Barclay's has been so heavily sought after as well as why the exchanges are a hot item on the auction block.
Last but not least, if "passive" indices are actually actively managed, then the idea that they will move with the market may be unwarranted. If they begin to vary wildly from the overall market, sector, industry, country, due to the competition between index providers, two people who invested in Energy ETF's could and should have entirely different results. Therefore the results of the buy and hold approach in a diversified asset allocation usually applied to them may have no real groundings in historical data and may be heavily dependent on which ETF is chosen.
Regardless of its implications it is important to understand that the ETF industry and its rapid growth and source of profits have caused those who produce an index to be interested in its alpha over its beta (aka performance over market representation). The effects of such an emphasis on performance should be used not only in evaluating the markets as whole but any portfolio being constructed.
Comments