Growing Pains

The debate from the Super Bowl of Indexing: It's a

Illustration By Mark Kseniak

Indexing was originally billed as a simple strategy designed to generate better long-term investment results than most active money managers. More than two decades after indexing first moved from concept to reality, it's clear that the strategy has delivered on its original promise. The bad news? Indexing has become big business on Wall Street.

Indexing has become complex. The industry of indexing now comprises a range of benchmarks, portfolio products, and derivative securities, making the decision to index no longer a simple one. Even the theory that indexing is applicable no matter what the market outlook came under fire at Information Management Network's fourth annual Superbowl of Indexing last December. Indexing guru John Bogle, founder of the Vanguard Group, derailed any real or perceived consensus among fans of passive investing by questioning whether a targeted, disciplined focus on small-cap stock indexing was really worth the effort after all. The line of inquiry was all the more relevant considering that it came from a man who founded a company that runs several small-cap index funds.

The "problem" with small-cap index funds, Bogle charged, "is that by maintaining what is called 'style purity' - never having the temerity to jump out of the small-cap style box - such a fund must sell its winners and begin all over again." In other words, a disciplined focus on small caps defeats the power of long-term investing. At the very least, the small-cap indexing strategy should be "reconsidered," he advised.

Later in the conference, another voice from Vanguard raised the point in a debate pitting active vs. passive managers by suggesting that active management in the small-cap arena is superior to indexing. For the 10 years ending December 1998, 87 percent of small-cap mutual fund managers equaled or outperformed the Russell 2000, the often quoted benchmark for the sector, noted Gus Sauter, manager of the Vanguard Index 500 Fund. In contrast, 86 percent of large-cap managers lagged the Standard & Poor's 500-Stock Index over that period. The data suggest that while indexing succeeds in the large-cap portion of the stock market, active management appears to have a better shot at providing benchmark-beating performance in the small-cap arena.

At another session, Mike Napoli of Wilshire Associates, the investment consultancy in Santa Monica, California, offered a possible explanation for why small-cap indexing seems to have stalled in recent years. Large companies are "cherry-picking" small-cap firms, he explained. In an effort to build companies through purchases of young, entrepreneurial ventures, larger companies are skimming off the cream of the small-cap world. The stocks left in the small-cap indices are too often unwanted stocks.

Napoli pointed to the buying binge underway at large technology companies, such as Cisco, Microsoft, and Lucent. Their deep pockets and aggressive acquisition strategies are taking the most promising stocks out of the index. The remaining companies tend to be second-tier players, and the market reacts accordingly, as evidenced by the lag in small-cap benchmarks relative to large-cap indices, he suggested.

If the integrity of indexing is threatened by growth, the risks were easy to overlook amid the buzz of the Superbowl of Indexing. The latest meeting set a new attendance record - 450 people by one count, the largest crowd for the annual event since its launch in 1996.

The glamorous location itself may represent a new high for indexing conventions. Belying the austere philosophy that accompanied the birth of indexing, the conference was held in perhaps the most regal of Phoenix hotels. The setting reportedly has been a favorite lodging choice for every occupant of the White House since Hoover, and at least one current Presidential hopeful is comfortable with the precedent. George W. Bush, a Republican candidate for the presidency, held a press conference at the Arizona Biltmore one morning during the indexing convention.

As for topics discussed, the pesky details of day-to-day management of index funds moved front and center during the conference thanks to a dramatic price jump by shares of Yahoo! on the day it joined the S&P 500. Soaring more than $65 - nearly 25 percent - on December 7, Yahoo! was perhaps an indexer's worst nightmare. The stock's drama, coming right in the middle of the Superbowl of Indexing, also triggered endless debate among conference attendees.

Rebalancing, as it's called, has long been a hot issue for indexers well before Yahoo! pushed it onto the front pages of financial news. The issue boils down to deciding when to buy stocks that are added to an index and when to sell those that are deleted.

For slavish indexers, the issue is cut and dry because they are blind to fluctuations of individual securities. For such passive indexers, all that matters is minimizing tracking error. If replicating the returns of the S&P 500 requires buying Yahoo! at wildly inflated prices, so be it. Indexers don't question the market, they merely track it. Or so traditional indexing philosophy dictates.

But as observers of the indexing scene know, nothing is sacred on Wall Street, not even within the devoted world of passive money management advocates. Standing idly by and letting the market determine the cost of managing an index is no longer universally accepted as par for the course among indexers. Certainly the stakes can be quite high when it comes to additions and deletions to benchmarks. For example, roughly one-quarter of the stocks in the Russell 2000 were deleted during the annual reconstitution this past June, said Ralph Goldsticker, director of investment research for Mellon Capital Management. The update of the benchmark produced major liquidity demands in the market, he noted in a lecture entitled "Rebalancing: Expense or Opportunity."

Predictably, the deleted stocks drifted lower after the announcement of the changes while the soon-to-be-added stocks rose in price. The actual rebalancing date came some three weeks after the announcement. The greatest spike in price among the new additions generally come on the eve of the rebalancing, driven by a fundamental change in supply and demand, Goldsticker explained. Some of that came from index funds, although a fair amount of buying is due to traders who are exploiting the knowledge that passive investors will ultimately buy the stocks. Indexers tracking the Russell 2000 were compelled to sell the stocks that were deleted and buy the stocks that were added.

In the old days of indexing, the process was fairly simple: buy the stocks on the day they're added to the index. But is that wise? Not by Goldsticker's reasoning, who said such auto-pilot thinking means that "slavish indexers are just inviting to be picked off," i.e., pay the higher prices on the day of rebalancing.

But Goldsticker says indexers should fight back. For starters, don't be predictable, he advised. "It's the predictability that allows you to be picked off." Trade early and trade often, he stressed.

Strategically rebalancing, as opposed to passively rebalancing, adds value, he continued - at least sometimes. Goldsticker reported that Mellon's active rebalancing approach added nearly 1.4 percent to its Russell 2000 index fund during the 1999 rebalancing. The strategy backfired a bit in 1995 and 1998 with slight losses, although it showed positive results in 1996 and 1997. "It's possible to add value in a passive index fund," Goldsticker concluded. Thoughtful trading, as he calls it, is the key. "This is true even though trading is expensive and the arbs are constantly trying to pick us off."

The rise of exchange traded funds (ETFs), which are essentially index funds that are listed and traded on exchanges like stocks, has opened up a new world of fusing active management with indexing. Several speakers highlighted the flexibility offered by ETFs in crafting what amounts to a custom index. As one example, consider an investment objective of indexing the U.S. market sans exposure to the energy market. The solution: buy the S&P 500 and short the Energy SPDRs (Standard & Poor's Depository Receipts), which are one of many ETFs.

Another strategy is to emphasize a particular sector, perhaps by owning an S&P 500 index fund and buying Technology SPDRs in such quantities so as to overweight the group relative to their value in the market overall.

The same philosophy can be applied to an international portfolio. Another group of ETFs called WEBS (World Equity Benchmark Shares) slice up the major stock markets of the world into individual index funds.

Owning narrow slices of securities markets via ETFs may be an efficient method of gaining exposure to the sector or market, but does it constitute indexing? Not necessarily. Buying index funds isn't inherently the strategic equivalent of ascribing to the passive philosophy. Simply put, ETFs can be used to speculate just as easily as they can be used to build a passive portfolio.

ETFs are also a "hot" item at the moment, Bogle recognized. The products "have taken indexing far beyond what any of us present at the creation a quarter-century ago could have imagined." But he also complained that ETFs are "frustrating the original purpose of the index strategy - efficient long-term investing in a diversified portfolio of business - giving us instead a vehicle for short-term speculation in the stock market."

Bogle reminded attendees that the real-time pricing mechanism of SPDRs, the original and currently the most-actively traded ETF, lures traders. In contrast, index mutual funds trade but once a day, at the close of the market. No wonder that SPDRs' annual turnover in 1999 was roughly 1,800 percent, or 22 times the 80 percent turnover rate of the average stock on the New York Stock Exchange. More recent ETF entrants post even higher turnover rates.

High turnover rates also raise questions about taxable gains, Bogle warned. As such, it should come as no surprise if ETFs' tax issue ultimately convinces taxable investors to choose conventional index funds, he remarked.

Bogle was even more critical of the more recent ETF products, including the 17 World Equity Benchmark Series, with relatively steep expense ratios in the 1 percent-plus range. He grumbled that the new ETFs have been designed with a purpose "diametrically opposed" to the intent of the first index mutual fund launched by Vanguard in 1975. "Our purpose was to create an investment that would serve long-term shareholders, to be bought and held, to be the hedgehog who knows one great thing rather than the fox who knows so many things... ." Simply put, that first index mutual fund was designed to bring simplicity rather than complexity to the world of investing.

Bogle charged that ETFs appear as though they're designed primarily as a means of delivering a highly marketable product to cash in on the indexing phenomenon. Regardless of whether the products serve investors well, ETF sponsors will be happy. Bogle reported that he heard an executive from a major ETF firm claim, "'Brands have always existed in consumer products. We see investors buying our brand just like they buy a brand of toothpaste.'"

Toothpaste? Bogle was dumbfounded that indexing was now being used as just another mechanism to sell product. That wasn't the original intention, he reminded. There's a big difference between designing a product that sells and creating an investment that serves. But perhaps Bogle forgot that on Wall Street the reverence for profit takes a back seat to nothing - not even indexing.

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