An index for every occasion

It’s hard to argue with an investor who chooses a fixed, low-price product with middling results over a fixed, high-price product that comes with considerable uncertainty about outcomes. The price gap between active and passive products is significant; that preference is entirely rational.

But there is more. In a world of efficient markets, indices are like information diamonds: the pitch black carbon of market intelligence is compressed into single indicators, built from multiple prices that reflect all available information in that market with a sparkle. In this way, they are ultra-efficient, representing the equilibrium in supply and demand.

They also are a perfect tool for anyone following the Black-Litterman strategic asset allocation model.[1] Since its publication in the early 1990s, Black-Litterman has become the leading allocation model - but has inflated the role of indices in investing in the process.

This is because Black-Litterman model allocation starts from the asset class weights in the benchmark index (the market-representative allocation premise), before adjustments are made to reflect the investor’s views on returns. The benchmark serves as the neutral starting point for all allocation decisions.

This leaves asset allocators with a natural affinity for indices. If you invest in a market cap index, the distribution of what you are buying should stay the same irrespective of how much money you pour into it. When money flows into (or out of) a market through an index, it is distributed representatively and allocators who follow the model do not need to adjust their positions.

And when everyone is in the same boat, the personal incentives for managers are skewed. Indices drive managers to ‘closet indexing’, an investment approach that is active in name (and fees) but in effect passive in outcome. When everyone else is at it, there is limited career risk in aligning to the index, but selecting securities for their longer-term potential can be quite a career gamble in the short to medium term, especially when a portfolio is much more concentrated than the index. When underperformance takes hold, you may not last long enough to prove you chose the ultimate winners.

Even when your case does not rest on longer-term opportunities generated by structural shifts, secular trends, innovation, or changing business models, you might find shorter-term value in securities mispriced by market dislocations or riding waves of behavioural biases. But when index investing becomes the norm, you can no longer rely on selling to the bigger fool.

Yet simple does not equal sound

As perfect as mathematical purity is to financial theorists, it matters not one jot to end-investors. Indices cannot be justified on their mathematical qualities alone; what matters for our pension pots is the outcome of our investment choices.

Although indices, in theory, embody perfect information, you would be hard pressed to find anyone who still believes in efficient markets with short-run price equilibrium. Inefficiencies arise from short-term distortions and medium-term oscillations around equilibrium prices, fuelled by both supply and demand overshooting. Demand and supply are imperfect information, not every potential buyer has access to the securities they might desire, and corporate actions such as share buy-backs can distort supply.

This means that on any given day, the market’s equilibrium pricing does not imply you are paying the right value. Contrary to common perceptions, there is no sanctity in current price levels.

Just as importantly, time horizons matter. There is ample evidence that companies are moving in and out of indices at a faster rate than ever before. The average tenure on the S&P 500 has dropped from 33 years in 1964 to 24 years and is forecast to shrink to just 12 years by 2027.[2] As an investor, what you really want is exposure to the companies that will lead the market in 10, 20 or 30 years, not those that are dominant now but will be quaint memories when we look back.

The list of such casualties is long. Nokia, Blackberry, Blockbuster, Toys R Us, Lehman Brothers, Reader’s Digest Association, Enron, and Kodak all spring to mind - household brands not too long ago, whose language entered everyday vocabulary (‘Kodak moment’). Even GE, an original and uninterrupted member of the Dow Jones for over 120 years and a giant only a decade ago, is a mere shadow of its former self.

High-conviction managers who are not constrained by an index can make the most of these opportunities. But they have to be genuinely independent, incentivised not to closet-track the index, to do their research, limit their costs, and be brave enough to stick with their highest-conviction positions through tumultuous times.

There is a place for indices in diversified portfolios. A universal cure, however, they are not.

Notes:

[1] The Black-Litterman asset allocation model was developed by Fischer Black and Robert Litterman of Goldman Sachs in the early 1990s, who combined two main theories of modern portfolio theory (the capital asset pricing model (CAPM) and Harry Markowitz's mean-variance optimization theory). The model aims to maximise returns for given levels of risk but incorporates the investor’s views on expected returns of different asset classes. The model first estimates asset equilibrium returns and then combines these returns with investors’ individual views to derive updated estimates. These are entered into a portfolio optimisation tool to generate an efficient allocation frontier. This results in intuitive, diversified portfolios, although the original model is often adjusted to account for additional constraints that prevent undesirable allocations (for example, large short positions). Key to the Black-Litterman model is that it takes the weights of asset classes in a global benchmark such as MSCI World as a neutral starting point, and then adjusts asset weights to reflect the investor’s views on expected returns according to the strength of these beliefs.

For Black and Litterman’s original work, see:

• Black F. and Litterman R.: Asset Allocation Combining Investor Views with Market Equilibrium, Journal of Fixed Income, September 1991, Vol. 1, No. 2: pp. 7-18.
• Black F. and Litterman R.: Global Portfolio Optimization, Financial Analysts Journal, September 1992, pp. 28–43 JSTOR 4479577.

The independently maintained Black-Litterman site http://www.blacklitterman.org includes explanations, examples, links to papers and comparisons of methods.

A step-by-step guide to the model’s method is available here.

[2] 2018 Corporate Longevity Forecast: Creative Destruction is Accelerating. Innosight, February 2018.