Active Index Investing's E-ppendix
Active Index Investing's E-ppendix
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PRAISE FOR THE BOOK
TABLE OF CONTENTS
BOOK PURPOSE AND INTENT
FOREWORD
PREFACE
ACKNOWLEDGEMENTS



 

 
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Active Index Investing, edited by Steven Schoenfeld, aims to be the definitive guide to the art and science of using index-based strategies to maximize performance and minimize the risks of global investing.   This short overview of the key sections of the book will indicate that in fact it is “Five Books in One” – providing a comprehensive exploration of the theories, benchmarks, investment vehicles, portfolio management techniques and overall benefits of indexing.  Active Index Investing was published in July 2004 by John Wiley & Sons as part of the Wiley Finance imprint and was favorably reviewed by the Editors of Pensions & Investments in January 2005.  It was also published in Japanese by Toyo Keizai in late 2005, with translation supervision by a team of academics (Yokohama National University) and industry professionals (Sumitomo Trust Bank and Northern Trust Japan K.K.)

 

Indexing is Active

For anyone who may have thought otherwise, in Chapter 1 editor Steven Schoenfeld of Northern Trust Global Investments guides us through all the reasons why Indexing is Active.  From the theoretical logic behind concept of indexing to the art and science of benchmark construction and index management, this opening chapter makes it very clear that indexers are playing anything but a passive game.   The chapter also traces the evolution of indexing, and provides a glimpse of the direction that this dynamic field is heading.  

Part One  (Chapters 2-4) The Indexing Revolution – Theory and Practice

Chapter 2.  So just how did indexing get its start?  In The Foundations of Indexing, Binu George, a portfolio manager at AXA Rosenberg, Steven Schoenfeld, and Jim Wiandt of The Journal of Indexes chronicle the evolution of portfolio management theories that explain why indexing is the most rational method of fund management.  From the inception of Markowitz’s theory of efficient portfolios, to Wells Fargo’s launching of the first index fund in 1971, and the regulatory change that cleared the way for indexing that soon followed, this chapter documents the foundations of indexing.  The outcome of this evolution is that the principles underlying indexing – focus on minimizing costs and controlling risks – are now shared by index and active managers alike.  

In Chapter 3, Binu George of AXA Rosenberg, Matt Scanlan, a Managing Director at Barclays Global Investors (BGI), and Steven Schoenfeld discuss the advantages of index products and the factors that have contributed to their meteoric growth in the U.S. in The Ever-evolving Uses of Indexing.  In examining how investors use indexing in increasingly sophisticated and creative ways, and how indexing can be a key part of an overall investment strategy, the authors stress that the indexing versus active debate is over, and that investors need not choose one over the other.  Rather, indexing should be viewed as part of a ‘mosaic’ in a holistic investment strategy that attempts to invest in broad universes of assets and asset classes.

Chapter 4, Market Uncertainty and the Role of Indexing by Adele Kohler of State Street Global Investors (SSgA). Like clockwork, each bearish market environment brings with it the claims that “this is when active managers will prove their worth” or that “indexing only works in rising markets.”   The previous chapter went to some lengths to dispel those myths.  However, in this chapter, Adele Kohler attacks them head on, writing from the perspective of 2003’s respite from a brutal three year U.S. equity bear market.  She draws heavily on publicly available empirical evidence, as well as some unique data points regarding active manager cash levels during market turns.   Her conclusion is consistent with that of Chapters 3, 26, 29 and 30,  namely, that a core allocation to index-based strategies is the ideal way to maintain the integrity of a well-designed strategic asset allocation – in any market environment.

 

Part Two.  (Chapters 5 –13) Benchmarks – The Foundation for Indexing

 

This section of the book discusses the role and importance of benchmarks for all of the world's major asset classes, and highlights the universal characteristics of appropriate indexes.  These chapters also discuss the primary characteristics and intangible risks within benchmarks, and answer the questions of what constitutes a good benchmark and what purposes they serve.   It also provides a comprehensive assessment of the major equity and fixed income benchmarks used by investors, and provides examples of the different ways investors use benchmarks and can customize them for individual purposes.

Chapter 5, The Vital Role and Fundamental Importance of Benchmarks, by Steven Schoenfeld of Northern Trust Global Investments, Larry Siegal of the Ford Foundation, and Pamela Cloyd, provides a critical foundation to understand the Four Key Uses of Benchmarks – as a gauge of ‘the market,’ as an asset allocation research and implementation tool, as a performance benchmark, and as the basis for investment vehicles.   The chapter also addresses some popular strands of criticism of benchmark use.

Two sidebars are also included, one being a review of why market capitalization weighting is, like democracy or capitalism, not perfect, but still better than any of the proposed alternatives, and the other focusing on the importance of float adjustment, using a robust example from the late 1990s.

Chapter 6. In Perfection Impossible, through a discussion of the key criteria for index construction methodology and their inherent tradeoffs, author Steven Schoenfeld explains why the quest for a perfect index might be a mission impossible.  For example, an index that is broad in coverage may lack investability since smaller names that contribute to index breadth will be less liquid, and one that rebalances frequently to accurately reflect constituent changes will lead to higher cost resulting from turnover.  Therefore, Steven points out that, in choosing a benchmark index, the user must carefully evaluate the purpose of the benchmark, and then be ready to make the trade offs based on their own preferences.  

This chapter includes two sidebars:  ‘Don’t Stop at Seven – Additional Criteria to Assess the Appropriateness of a Benchmark Index,’ by Steven Schoenfeld; and ‘The Impact of Benchmarks on Markets and Institutions,’ by Larry Siegal.   The former sidebar was originally used in a Journal of Indexes article by Schoenfeld in 1999, and was subsequently integrated into two research pieces published by BGI (and has since been adapted by both BGI and NTGI for various in-house publications. Another valuable contribution on this subject, ‘The Balancing Act of Constructing Benchmarks’ by Khalid Ghayur, is a Web-only sidebar available on this site which supplments the points made in this and the following chapter.

Gus Sauter, Chief Investment Officer of the Vanguard Group, provides his view of the optimal way to create indexes in Chapter 7 – Ideal Index Construction. As an important contrast to the views expressed in the previous chapter, this chapter is a slightly condensed version of an article written by Gus Sauter in Spring 2002 and published as “Index Rex” in The Journal of Indexes.  This article sparked considerable debate within the indexing community, much of which continues (and is covered in detail on IndexUniverse.com).   Furthermore, a number of Gus’ proposals were adapted by certain index providers, and are being carefully watched by others.    It is hoped that these contrasting views, and other index methodology issues raised throughout Part Two of the book, help readers understand the key factors and nuances of benchmark design and construction – and why it matters.

This chapter also includes a detailed sidebar by Steven Schoenfeld and John Spence that provides an overview of the key global index families and the companies that calculate them, which is supplemented here on the E-ppendix by Web-only sidebars written by executives of these index providers.

Chapter 8.   While there are many ways to segment markets in order to measure their movements, only those that are intuitive to investors and are derived from empirical evidence should be accepted.  In discussing the development of the style segments and how indexes are constructed to measure the market segments in “Splicing and Dicing the U.S. Equity Market,” Chad Rakvin, Gardner Platt and Brad Pope point out that the definition and application of style are by no means universally agreed upon, and that they are defined differently by different investors and index providers.  They then go on to discuss the challenges in developing benchmarks for these segments where such differences exist.   The chapter also includes a comprehensive overview and assessment of broad-cap U.S. equity benchmarks.

To supplement the chapter, two sidebars are included that expand the coverage to two additional index families.  The first is ‘MSCI’s New U.S. Equity Index Family, by Eric Brandhorst.’

The second is an overview of the new S&P/Citigroup U.S. Equity Benchmarks, by Melinda Chu.

In addition, a ‘web-only’ sidebar by Arlene Rockefeller of SSgA takes a close look at the S&P SuperComposite index.

Chapter 9, International Equity Indexes by Steven Schoenfeld and Robert Ginis of Global Index Strategies, addresses the evolution of international benchmarks in the context of the changing face of the global market brought on by cross border mergers and acquisitions, increasing integration across countries and sectors, and the growth of emerging markets.  Given this heightened profile of global markets, and the explosion of choice in international benchmarks, the authors’ goal here is to provide North American investors the perspective and data to align their international equity framework with the new world markets by addressing such issues as how key international index providers make index construction decisions, how these indexes measure up to the seven criteria of a good benchmark, and what transition costs are involved in switching benchmarks.

Chapter 10, Fixed Income Benchmarks by Mark Friebel of BGI and Vache Mahseredjian, discusses the features that are characteristic in bond indexes, and those that are required in a good bond index. The author addresses the questions of how much does choice of indexes matter, and why bond indexes are different from equity indexes.  For example, the author points out that,within a single market, most of the major bond indices are over 90% correlated with each other with most differentiations occurring over smaller bond issues, or over a limited number of structures, such as bonds with put or call features, which may be included in one index, but not in another. Therefore, the choice of benchmark index often becomes a decision based on finer points.   However, with the advent of Bond ETFs, fixed income indexes will become increasingly prominent.

The accompanying sidebar is an in-dept look at commodity indexes, by David Burkhart and Mark Friebel.

In Chapter 11, Mark Anson, Chief Investment Officer of the California Public Employees Retirement System (CalPERS), gives a comprehensive analysis of the rapidly growing field of hedge fund benchmarks and universes.     This chapter aims to provide an overview of the burgeoning field of hedge fund performance measurement and benchmarks.   It defines the methodology, scope and limitations of these ‘universes’ and how investors are increasingly using them for asset allocation.  Although many would argue as to whether the new “investable” universes are indexes at all, it is clear that the industry will be using them in a similar way as equity and fixed-income indexes, and thus it is vital to understand their construction methodology, and their relative strengths and weaknesses.   Furthermore, hedge fund indexes are beginning to be used as the underlying basis for index funds, and potential investors must understand the attributes of these products.  A sidebar by Simon Hookway and Steven Schoenfeld  – The Expanding World of Investable Hedge Fund Index Products – supplements this chapter.

Chapter 12. The Utility of Indexes as Analytical Tools, by Mark Sladkus of MSCI, shows us that indexes capture and reflect what we as a society have lived through both in economic and political terms.  Broad market cap weighted benchmarks, such as the MSCI Indices, published since 1968, can be used as a reference to observe the evolution of markets. Because these and other benchmarks are designed and maintained to reflect the structure and evolution of the markets, an analysis of these indexes often provides a snapshot into changes in the world’s economy, such as trends in markets, economies, and commodities.

Chapter 13. Rounding off this section, Peter Wall of Wall's Street Research offers a comprehensive overview of the concepts of socially responsible investing and corporate social responsibility, and looks at some of the factors reinforcing the rise of Socially Responsible Indexes and propelling them into mainstream portfolio investment around the world.  And in sync with the theme of this book, Peter makes the case that passive investment strategies in the SRI field may be the most active investment decision one could ever make!   

 

Part Three. (Chapters 14-18)  The Ever-Expanding Variety and Flexibility of Index Products

 

Chapter 14.   The Wide World of Index Products – Building blocks for an efficient portfolio.  Index funds, index derivatives, and hybrid index products - all are part of the index family that continues to expand to meet different investor needs.  This section, by Joy Yang of AXA Rosenberg and Steven Schoenfeld, takes us through all the wealth and depth of index products, their management techniques, and the purpose they serve as building blocks of an efficient portfolio.  Consistent with the theme introduced in the beginning of the book, this section demonstrates by example why index investing involves so much more than passive investing, and that the latter is simply one sub-category of indexing. 

Three sidebars accompany this chapter:

  • Definitions of key indexation/quantitative finance terminology 
  • Indexing in China, by Yi Zheng Ph.D
  • Indexing in Brazil, by Steven Schoenfeld and Stephen Wallenstein

Chapter 15, Enhanced Indexing – Adding Alpha in a Disciplined, Risk Controlled Manner describes the skills and resources required to implement successful enhanced index strategies.  Joy Yang and Steven Schoenfeld guide the reader through a discussion of “index plus” portfolios constructed solely with securities as well as derivative-based strategies, two broad categories that add alpha by taking advantage of capital market imperfections and index methodology idiosyncrasies.  In order maintain a successful strategy with positive information ratio, the manager must be able to identify the opportunities, diversify risk by diversifying the source of alpha, and keep costs down.     A streamlined version of this chapter was published in the Journal of Indexes (Fourth Quarter 2003) and has already generated substantial debate within the investment community.  

Chapter 16. The Flexibility of ETFs – The Best of Both Worlds?    Yigal Jhirad, Omer Ozkul and David Qian of Morgan Stanley provide a comprehensive overview of the rapidly growing field of Exchange Traded Funds, with a focus on U.S.-listed products.  They explain the product structure, and the variety of uses and users of the products.   The chapter also provides case studies of applications of ETFs by a variety of institutional users. 

A sidebar on Fixed Income ETFsprovided within this chapter- ‘Fixed Income ETFs in Europe – A New Revolution for European Investors,’ by Elizabeth Para - explores how ETFs are branching out to overseas exchanges. 

In Chapter 17 - Indexing Real Estate by Jim Keagy of BGI.  In recent years, a variety of indexes and index products have been developed for ‘alternative’ asset classes such as commodities, real estate and hedge funds.   While some would argue that these asset classes are “unindexable,” the reality is quite different.  The availability of index benchmarks and investment products based upon those indexes is, in fact, considerable, and both serve to better define the opportunity set for investors as well as increase transparency of the asset class.   In this chapter, real estate veteran Jim Keagy makes the case for indexing real estate and in the process sheds some light on the benefits of including the asset class in portfolios.   He provides an overview on real estate investment trusts (REITs), which form the basis of publicly traded real estate investments.  REITs are the primary constituents of most real estate indexes.  He describes some of the benchmarks and products available to investors, and shows how some institutional investors use indexed real estate products in their portfolios. Readers will find that much of the same logic that undergirds the case for indexing stocks and bonds is also present for real estate.

Chapter 18.  ‘Active Indexing’ – Sophisticated Strategies With Index Vehicles   Implementing sophisticated institutional strategies and asset allocation with index products is all about combining the efficiency and transparency of index portfolios with an infinite variety of allocation approaches.  In this chapter, Steven Schoenfeld, Robert Ginis and Niklas Nordenfelt of Wells Fargo Bank look at different potential weighting schemes, both within asset classes and in multi-asset class strategies, and assess the benefits of these approaches.    A detailed example of the rationale and structure of an alternatively-weighted approach to emerging market indexing is included.

Sidebars included within the chapter:

-          Use of Index Funds for Rapid Asset Allocation across Countries and Sectors – an interview with Aje Saigal of the Government of Singapore Investment Corporation.

-          Using a Value Index Strategy to Address Style Mismatch – by John Krimmel of the Illinois State University Retirement System provides an excellent case study of risk budgeting in action, through his plan’s addressing a major ‘risk hole’ with a value-oriented international index strategy.

Web-only sidebars in the book’s E-ppendix, that supplement the chapter include

-          The Active Index Strategist – How Investors and Traders Can Use ETFs and Index futures/options to Implement Technical Market Signals, by Steven Schoenfeld

-          Hedge Fund Indexing – A Square Peg in a Round Hole?  by Adele Kohler of SSgA

 

Part Four. (Chapters 19 - 24)  Managing Index Funds – It’s anything but passive

This section provides a unique insider’s perspective into the art and science of managing index funds, much of it never-before detailed in print.   Written by seasoned index fund managers, these chapters describe the fundamental concepts and techniques of equity and fixed income index managers in minimizing costs, controlling risk, generating “index alpha,” (not always an oxymoron!)  and minimizing tracking error.  The section also provides insight into the complex and unique challenges of managing the multiple dimensions of risks in and less-efficient parts of the U.S. stock market, within fixed-income portfolios, in international equities, and in emerging markets.

Chapter 19.   Steven Schoenfeld and Kevin Maeda provide an overview of how index portfolio management is “anything but passive” and detail the fundamental index portfolio management techniques that are used by most index fund managers.   Portions of this chapter are adapted from lectures that Steven has delivered at Duke/Fuqua and UC Berkeley/Haas business schools.    The authors also provide key definitions and explanations of terms used throughout this section.     A sidebar by Jim Creighton, Chief Investment Officer of Northern Trust Global Investments, is a provocative examination of the challenges of trading index changes.

Chapter 20.  How difficult can it be to manage assets in the world’s most efficient and liquid market?  We might be tempted to think that it is comparatively easy task but we’d be wrong.  Truth is, the depth and breadth of the U.S. market brings a multitude of complexities.  In this chapter, The Unique Challenges of US Equity Index Management, current and former members of BGI’s U.S. equity index portfolio management  team take us through how they handle the complexities they face such as corporate actions, stringent tracking error tolerances, multiple choices of indexes, and their trading strategies in an efficient market, and their use of derivatives in the management process.

Chapter 21.  Delivering performance in international indexes requires many of the same skills as in U.S. equities, but often requires a unique focus on different factors.  In this chapter, Steven Schoenfeld and some of his former international equity index portfolio management colleagues detail the key challenges to deliver performance in both developed and emerging equity markets.   The complexities of multiple time-zones, market conventions and regulatory factors are described, as well as detailed examples of trading strategies and cross-border corporate actions.

There is a sidebar on ADRs and ADR Indexes: ‘More Taste, Less Filling,’ by Kevin Maeda and Steven Schoenfeld 

A Web only sidebar – ‘Managing Political and Financial Risk in International Index Funds from B-Z – Brazil, Malaysia, Russia, Zimbabwe 1997 – 2000,’ is by Steven Schoenfeld and Robert Ginis.

Chapter 22   In Managing Fixed Income Index Funds, Elizabeth Para and Partha Dasgupta of BGI explain in this chapter how fixed income indexing differs substantially from equity indexing.  They detail several non-derivative and derivative based methods of creating an index tracking fixed income portfolio and why these methods have won over active investors.  They then evaluate each of these methods and their advantages and disadvantages, and market circumstances under which each method is practicable.   A discussion of Bond ETFs is also included.

In Chapter 23, two ETF portfolio managers at BGI in San Francisco, Lisa Chen and Patrick O’Connor,  provide insight into what it takes to manage an ETF portfolio and how it’s different from managing indexed funds.  This detailed chapter addresses all possible questions you may have about the intricacies of ETFs from portfolio management strategies that focus on cost control to regulatory guidelines, tax harvesting strategies, and turning a portfolio of stocks into a share of ETF.  This is a real behind the scenes look at all that’s involved in ETF portfolio management. 

Chapter 24 explores one of the newest, but potentially most value-creating areas of indexing – the management of index-based separate accounts for individual investors.    In this chapter, Steven Schoenfeld, Kevin Maeda and Mark Adams describe the key challenges of tracking benchmarks within the constraints of relatively small individual accounts, especially when customization is applied.

 

Part Five.  ( Chapters 25-31 ) Pulling it All Together – How to use index products to build an efficient, risk-controlled investment strategy

 Joanne Hill and Barbara Mueller of Goldman, Sachs, in Chapter 25, explore how an institutional investor can choose amongst the even-growing variety of index-based investment strategies and products.   The chapter explores the key decision criteria for different users (tax-exempt plans, active managers, hedge funds, etc)  and looks at the pros/cons of use of each type of index vehicle (index funds, ETFs, futures, OTC swaps and structured products, etc).

Chapter 26.  How and Why Large Pension Plans use Index-based Strategies as Their Core Investments.  This chapter, by Nancy Calkins of Washington State Investment Board, looks at the ways that pension plans use index funds – whether as a core holding complemented by active satellite portfolios or with actively managed portfolios playing the lead role and index funds filling the gaps and reducing risk.   It also depicts some of the ways the basic index funds can be used as building blocks to create “active” portfolios. 

Recent market volatility has resulted in some pension plan assets to fall and liabilities to rise.  Although there are no easy solutions to these situations, being cognizant of the pension plan’s risk exposure, understanding the asset/liability characteristics, and maintaining a long-term perspective will assist in the development of a structure that fits the plan’s needs.  Clearly, index funds, with the flexibility they bring, will continue to have an important role in the structure of each pension plan. 

In addition to Nancy’s chapter, the book includes three informative ‘sidebars’ on other large institutions’ use of index strategies:

-          Japan’s Pension Fund Association’s use of Index Strategies – Yasuchika Asaoka. Executive Director – PFA

-          State of Oregon’s Blend of Index and Enhanced Index Strategies – Mike Mueller – Oregon Treasury

In Chapter 27, Tax Efficient Indexing , Mark Zurack, a former Partner at Goldman Sachs who now teaches at Columbia University, details the trade-offs and choices an investor faces when adding tax considerations into the index-based investment equation.    

Chapter 28    Indexing – A Sophisticated Investment Strategy for Professional Advisors and Their Clients provides the framework for advisors and investors to develop and implement an intelligent investment program through index strategies.  Michael Chassnoff  of TruePoint Capital  concludes that it is a sensible framework for establishing a long-term investment strategies that take into account the investment objective, investment time-horizon and a realistic expectation of securities markets over the long-run.  A sidebar by Joyce Franklin of JLFranklin Wealth Management discusses the way advisors can use ETFs to minimize taxation in their clients’ portfolios

Chapter 29. The Compelling Advantages of Indexing for Individuals is an excerpt of a recent publication The Great Mutual Fund Trap.   The authors, Greg Baer and Gary Gensler, both former U.S. Treasure officials, recount the many traps that sensible people seem to fall into when it comes to making investment decisions.  With a handful of statistics and comic anecdotes, they remind individual investors that past performance really isn’t indicative of future performance, that paying front loads and back loads defy common sense, and that while index investing may be less fun, it can certainly be more profitable, as U.S. civil servants participating the government’s Thrift Savings Plan know very well.

Chapter 30.   Indexing at the Core and the Four Key to Long-Term Investment Success   by Steven Schoenfeld.  This chapter highlights some of the key macro concepts of investing, and how index product can be used to implement them.   These four key concepts are:

-          Determining appropriate diversified asset allocation.

-          Using risk-budgeting to determime appropriate manager/strategy allocation

-          Disciplined rebalancing

-          Explicit and implicit cost control  - the one thing you can always control

It includes and overview of best practices (not just for indexing) with extensive references to more detailed information on practical implementation issues, including ideas on how to access the best index-based strategies and products.

The book's concluding chapter – The Future of Indexing … the revolution has just begun!  -- summarizes the key themes of the book, and provides some bold predictions for the future of indexing in world markets.   A shorter, ETF-focused version of this chapter was published in Institutional Investors’ http://www.iiguides.com/ Fall 2003 ETFs II – New Approaches and Global Outreach, and an excerpt of the chapter was published in HaBorsa, the monthly magazine of the Tel Aviv Stock Exchange.

 The book also includes an extensive Glossary and Bibliography, supplemented by this  “Electronic Appendix” – or E-ppendix –  which provides further information about the book and it’s contributors and  an “E-ppendix” of current data and research, more extensive glossary, useful web links, and tools for indexing novices, academia and industry professionals.  This path-breaking E-ppendix is further supported and enhanced by a the investment industries most comprehensive indexing website -  http://www.indexuniverse.com/.     





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