Market indexes have come a long way in the last 25 years. Today, more than ever, indexes can be effective tools for financial advisors in constructing client portfolios, provided one knows how to best take advantage of them.
In the early 1980s, the use of market indexes in investment management was still in its infancy. Professional investors were just beginning to use indexes as benchmarks for their performance. But their use as the basis for passive investment vehicles was limited.
As better measures of markets were created the use of indexes matured rapidly, both as performance benchmarks and passive investment vehicles.
At first, the most widely used indexes weighted companies based on their market capitalization as prescribed by financial theory with the clear distinction that any investment strategy that weighted companies otherwise was by definition an active investment strategy.
In more recent times, the rapid popularization of ETFs has caused a seismic shift in index design. Indexes are still widely used as the basis of passive investment vehicles, but they have clearly evolved and are considered to measure more active strategies than ever before in their construction and use. The rate of innovation in this industry has been phenomenal with continued evolution of product design, positioning and portfolio applications to meet the changing needs of investors.
Through the 1980s and 1990s, indexes rapidly expanded into new asset classes, markets and investment styles, with increasing sophistication of construction methodology and new ways to segment the investable universe to track and measure changing market and investor behavior.
In the last decade or so, indexes have also moved aggressively into a new phase of development, what we refer to more broadly as "rules-based strategies." While still having the traditional index characteristics of being rules-based and transparent, these new indexes behave more like active strategies.
Many replicate a certain type of investment style or behavior. Some examples of the many new alternative approaches include indexes that weight companies by measures of company size other than market cap, indexes that provide exposure to a certain investment discipline such as GARP or momentum, and indexes that provide investors exposure to certain types of stocks, such as high dividend paying or low volatility.
Index use has also expanded, from that of benchmark to serving as the basis for investable products such as exchange traded funds, listed derivatives and structured products. These relatively recent developments have further accelerated evolution, driving the industry to design indexes more closely replicating what some may consider active investment styles. This has further blurred the traditional distinction between passive indexes and actively managed portfolios.
Today, the scope of index approaches and expanded access to indexes as investment strategies translates to much more powerful tools for financial professionals and their clients.
Market capitalization-weighted indexes have retained their original value as passive benchmarks to measure and track investment performance, and as the basis for investment vehicles that can provide investors with broad market exposure at low cost.
But with the advent of ETFs and other investable product structures based on indexes, investors now have a wider variety of ways to efficiently express a certain view on the market and gain exposure to a certain set of stocks or certain style of investing.
Here at Russell, for example, our fundamental and equal weight indexes represent a set of securities similar to broad market cap-weighted indexes, but they weight those securities differently within the index according to a certain investment formula. And other Russell index approaches look to replicate specific active investment strategies, such as the Russell Investment Discipline Indexes, or certain risk factor exposures, such as the Russell-Axioma Factor Indexes.
One important benefit for financial advisors from this rapid innovation is that index-based products can provide a very efficient way to deliver an actively managed asset allocation model to clients.
The transparency and consistency that indexes offer make them ideal for investors who want to assemble a portfolio with exposure to various asset classes or investment styles, but without the added cost and effort to evaluate and select active managers. Index-based products can also be used to make tactical weightings in specific areas or increase or decrease exposure to a certain risk factor.
So while they remain passive vehicles, indexes can help a financial advisor design and implement an active asset and risk allocation strategy.
As indexes have become more advanced—from the relatively straightforward and well-understood market capitalization approaches of 25 years ago to the more sophisticated vehicles of today—users must enhance their knowledge and judgment to use them properly.
Although indexes provide complete transparency, there are still potential risks. Advisors need to become more sophisticated to cope with increasingly complicated and volatile markets and understand how index-based financial products can play a role in clients' investment portfolios.
It follows that, as providers, we cannot create indexes solely for the purpose of making an investment sale. At the core, indexes must solve a client need, whether it is effectively measuring performance or effectively replicating performance of a certain section of the market within a broader asset allocation scheme.
Indexes must be based on the identification of suitable investment strategies that have merit or on the discovery of a new way investors are managing assets that needs to be effectively measured.
New indexes cannot be based on simply back-testing performance and launching products with a desirable historical track record. In short, quality rather than quantity must continue to be the focus of index providers as the industry continues to evolve.
Rolf Agather is managing director of research innovation for Russell Indexes, a producer of global indexes and part of Russell Investments.