The Indexing Fad

Last Friday, Bloomberg published a rather astounding development: There are now more "market indexes" in existence than there are US stocks.

Now, their data are proprietary and not described in detail, so it isn't totally clear what they're counting as indexes here. For instance, there are oodles of sector indexes that are subsets of broader indexes like the S&P 500-are they included? Also, it isn't clear whether we're talking US-only or global, stock-only or bonds/REITs/other securities, or other finer details. But, considering over half of these indexes were born since 2012-and all those sector-level indexes are more mature than that-it seems fair to say a good chunk of these indexes are what the industry calls "smart beta." Bloomberg suggests as much:

What drove the jump?

Demand. Many new benchmarks essentially repackage active investment strategies into indexes, says Eric Balchunas, senior exchange-traded fund analyst at Bloomberg Intelligence. They can then be tracked by so-called smart-beta ETFs, which fund companies are rolling out rapidly. ... Money managers are under pressure to cut costs, says Balchunas, as investors shift their money into funds with low fees.

Smart beta, the latest and (not) greatest industry catchphrase, is jargon for indexes that are manually constructed and actively managed, with companies selected according to some arbitrary criteria the manager believes will drive sustained outperformance over traditional indexes like the MSCI World and S&P 500. The general belief is that these stodgy, capitalization-weighted indexes miss opportunities to capitalize on companies' supposed tendency to outperform if they have higher book value, higher revenues, higher dividends or some qualitative quirk numbers can't capture. In the old days, before passive investing became all the rage, companies would have managed mutual funds centered around these themes. But now, with passive so hot, we instead have newfangled indexes-with ETFs tracking them. There are high-dividend indexes, low-P/E indexes, high-revenue indexes, indexes of companies with female execs, probably even indexes containing only companies whose names start with T and employ at least five Bobs.^[i]

In other words: "Passive" investing has become so popular that active managers are wrapping active strategies into passive wrappers so they can get in on the passive craze. It's all a big masquerade. We'd be inclined to live and let live and sing a little ode to free markets and innovation, but the smart beta phenomenon is also a bit troubling. Some of these products reek of financial snake oil. Actively managed mutual funds may follow similar themes, but their human element is advertised and taken as a given, along with all the inherent fallibility. Many smart beta funds, however, have more of an academic sheen, boasting back-tested returns that allegedly prove their pet factor (or factors) is a one-way ticket to outperformance. Trouble is, these back-tests are often pseudoscience, an exercise in datamining.

Don't take our word for it. A new study from some University of Cincinnati and Ohio State researchers dug into 447 "supposedly repeating price patterns" to see if they could replicate the findings with a broad, credible dataset and no torturing of data. As Bloomberg explains, they couldn't:

The authors' inquiry involved taking market anomalies previously observed by other researchers -- say, that certain cheap stocks tend to move in a predictable direction -- then trying to replicate them in their own data. Often, they found nothing but noise. Of 447 anomalies examined, 286 generated statistically insignificant predictions for stocks in the category, and the record was much worse for certain kinds of trading signals.

Broadly, the authors said that the signals failed because their discoverers had considered too broad a universe of stocks when they set out to confirm their findings. Tiny companies make up the majority of stocks, they noted, but represent very little market capitalization -- and yet that's where a lot of the anomalies work best. They posited various flaws of analysis that led earlier academics to give too much emphasis to these stocks in their research. ...

The authors said that identifying market anomalies is a "prime target for p-hacking," which, generally speaking, refers to shaping data to fit a preset conclusion. The data are inherently empirical, giving researchers flexibility in manipulating samples, defining variables and choosing methods. There's also a financial motivation for finding new aberrations "with trillions of dollars invested in anomalies-based strategies in the U.S. market alone."

Yep, all marketing. And it all creates big problems for would-be passive investors: How the heck do you choose what to index to? Do you go with something broad and boring, like the S&P 500, or something narrower and flashier? Do you go all-US, since most passive products are US-biased, or do you try to engineer something global? Do you go textbook passive, trying to mirror the entire broad market, or do you get cute with a few niche or "smart" indexes? And if you do the latter, are you really passive at all?

All of this underscores a salient point bond guru (and nascent Twitter superstar) Jeff Gundlach made at an industry conference last week: "Passive investing is just a myth." As he noted, even the S&P 500 is technically actively managed, with a committee selecting its constituents from a universe of over 4,000 US stocks. Hence, even a passive investor using only one S&P 500 index fund for all of space and time technically has an actively managed portfolio of select US large cap firms, albeit one with very low turnover.

If you can be that kind of passive investor, great-history shows you'll do very well. But experience also shows you are rare and might not really exist, because basic human emotions-fear and greed-constantly pummel even the most stalwart set-it-and-forget-it folks. Those emotions make people want to do things like chase heat or sell at the bottom of a downturn. From DALBAR to Morningstar, there is a vast body of research showing fund investors trade too frequently to reap the full benefits of long-term investing.

Everything has its day in the sun and the rain, and newfangled smart-beta ETFs, no matter how much they're back-tested, will have their stormy patches. There is no such thing as a permanent edge in investing. Markets are too efficient for that, and they are cyclical. Smart beta is also largely untested, as it proliferated during this bull market. Like other investing fads before it, there is a risk it vanishes in the next bear market as people panic and assets flee. We aren't inherently against all of them, and we reckon investors who pick relatively diverse funds with wide backing can probably get market-like returns over time if they stay disciplined through the ups and downs. But we'd think long and hard before hopping on the bandwagon.