Does Everyone Really Understand the Complexity of Index Investments?
Third in a series of posts on the sales and marketing implications of the ongoing debate between active and passive management. Read the first and second posts.
Back the spring of 2009, David Swensen, who oversees Yale’s endowment, gave an interview about his investment principles. A frequently-repeated quote from the interview is:
With all assets, I recommend that people invest in index funds because they’re transparent, understandable, and low-cost.
The word that jumps out to me is understandable. I think most investors and financial advisors would reflexively agree that index vehicles are exactly that – a tribute to the way they have been described and marketed.
But there is a variable involved in index investing that makes me wonder if everyone understands index products as well as they believe they do: the underlying indices. We spent some time digging into a variety of investment indices, leading us to two conclusions:
- Indices are Complex: An index is an easy concept in the abstract, but not so in practice. For example, to fully digest the methodology behind the creation/maintenance of MSCI indices, you’re going to need to read 119 pages of information. And consider how different theories have emerged on how indices can be best constructed.
- Indices can be Volatile: The components of indices vary regularly, and sometimes significantly. For example, almost 700 securities were added / removed from the MSCI Small Cap indices at the end of last year. Even the US Large Cap 300 index had 5% turnover in November 2010.
In addition, index updates sometimes occur as infrequently as every six months. 2008 did a lot to remind everyone how much can change in six months.
In the marketing of investment vehicles, index investments are presented as the simplest, most straightforward option. As Mr. Swensen stated, they’re understandable. But as we talk with advisors, they typically get indices conceptually but not in great detail. Data like that presented above catches many by surprise.
For firms positioning themselves and their products against index investments, this represents a way for marketing and sales teams to potentially change the conversation.