The greatest weakness of the current generation of index funds is that most of the benchmark indexes they use as templates were created and published for other purposes. Anyone can buy stocks added to the index or sell stocks removed from the index in competition with the index fund. No active fund manager would accept an investment process that would tell the world what trades her fund would make and approximately when it would make them. With Silent Indexes, index funds can achieve the same kind of trading confidentiality that actively-managed funds enjoy.
For more up-to-date information see The Exchange-Traded Funds Manual, 2nd Edition,
Chapters 5 and 7.
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Indices are designed for a number of different purposes. The use of stock indices as market indicators predated the idea of a theoretical “market portfolio” by decades.
Understanding the nature of these indices – and understanding the differences among ETFs based on them – requires understanding the answers to six questions:
- Is the index comprehensive or sampled?
- Is the inclusion mechanism rules-based or discretionary?
- How is the index weighted?
- Are inclusion and weighting decisions consistent over time?
- Can the index be sensibly subdivided – e.g., into industrial sectors, or growth and value components?
- Is the index so widely used as a fund template that the cost of its composition changes hurts the return of a portfolio using the index as a template?
Some of these issues are addressed in Chapter 7 of the 1st Edition of The Exchange-Traded Funds Manual, and in Chapter 5 of the 2nd Edition. Both chapters are useful, but very different.
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Most ways of breaking down the common stock universe from a total market index into sub-categories are easy to understand. Of course, there is not universal agreement on where size cut-off points or ranges belong or even what industry or sector every company should be assigned to, but most classifications are not too highly controversial. There is -- and should be -- significant controversy over how to divide the stock universe into growth and value components.
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These two articles extend the analysis of “The Benchmark Index Exchange-Traded Fund Performance Problem” and are part of a growing literature on the problems caused by too much money tracking too few overly popular indices that reveal index changes to the world before the fund manager has the opportunity to change the fund portfolio.
Updated information on the topics addressed in these papers is in The Exchange-Traded Funds Manual, 2nd Edition, especially in Chapter 5.
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Whatever the merits or demerits of fundamental indexing, intellidexes, active indexes and other recent additions to the workload of future generations of lexicographers, there is no scope for narrowing the definition of a financial market index. The cat is out of the bag, the horse has been stolen from the barn and, of course, Elvis has left the building.
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