The untold story of index funds

Your Funds

For years, investors have been hearing the rhetoric about index investing being better than active management.

You’ve heard the statistics and seen the results, but here is the part of the story that has been missing: There are plenty of indexes that are not worth investing in, or that might not deliver the classic index-fund advantages, or that might be worse than whatever goes through the mind of an active stock jockey.

To see that, you have to look beyond the pool of thousands of index funds and ETFs (exchange-traded funds), and instead consider the total population of indexes.

For the first time in history, we know just how big that community of indexes is.

For weeks, I have been asking experts just how many indexes they thought were in existence. Jack Bogle, the founder of the Vanguard Group and the industry’s first index fund, guessed around 2,500, and most experts were in that neighborhood. Several assumed it would be more than the number of stocks, which would have put it in the 4,500 to 10,000 range, depending on how you count stocks.

No one was prepared for the actual answer.

According to the first-ever survey of the Index Industry Association — a global organization of index administrators — there are 3.288 million indexes worldwide, and 95 percent of those measures are tied to stocks.

This mapping of the index universe was done last summer and released recently, and the Index Industry Association was getting actual information, not guesses, from each member about its indexing activities. Due to the size of the membership, the group thinks the 3.288 million benchmarks represent about 98 percent of the indexes available globally.

That means the real number of indexes is closer to 3.35 million.

The implications for the industry are massive, and so are the trickle-downs for investors and what might become available in the future; we will explore that here today and over the next two weeks.

First, however, some context on the stunning numbers.

Rick Redding, chief executive officer at the Index Industry Association, noted that there is a difference between an index being used as a benchmark and one that can become an actual investment vehicle. “The conundrum all indexers have to think about is that you want something that is representative of the underlying market,” Redding said, “but you also want it to be investable.”

Many benchmarks are private and proprietary measures, done by institutions for clients who want to view the market through a specific lens. There also is some inflation in the top-line number, because some indexes are kept multiple ways, like a foreign stock market benchmark that is measured both in dollars and euros would be considered two indexes. There also are cases where multiple firms keep their own version of a specific benchmark.

That inflates the number but hardly explains why the greatest minds in index investing were guessing at the population of indexes and were wrong by factors of 99.5 percent or more.

The Index Association had members describe their own activities: 42.7 percent of the indexes are tied to specific sectors or industries, 14.8 percent look at the total market, 10.8 percent are large-cap benchmarks and 5.6 percent are “smart-beta” issues, rules-based benchmarks where portfolios can be highly fluid and active.

One of the common things said against active management is how many fund captains fail to beat their benchmark or the average issue in their category. It’s a fair question to wonder how many benchmarks — including legacy indexes like the Standard & Poor’s 500 — beat the average among large-cap indexes.

Just before the internet bubble burst and the bear market of the early 2000s started, the popular statistic was that 88 percent of fund managers failed to beat the S&P. At that time, however, Morningstar tracked 100 indexes, and 98 of those benchmarks also failed to beat the S&P.

The sheer number of indexes does not in any way invalidate the benefits of index investing, but it should raise some questions about investment products old and new, and it should change the debate from active-versus-passive to active-versus-rules-based-versus-passive, thereby accommodating that massive population of benchmarks that is a lot more active than anything Bogle and his early band of Vanguard pioneers were dreaming up.

Clearly, not every index or index fund is a good idea. Defunct and mostly forgotten issues like the Stock Car Stock Index fund — which tried to capitalize on the popularity of NASCAR — and the Tombstone Index (which tracked the few public companies in the funeral and death-care business) proved that indexing alone can’t turn bad investment concepts into good ones.

But if the volume of indexes is at least some 650 times greater than most experts believe it to be, there is a lot more mediocrity and silly thinking being pursued than we know.

The methodology — and the reasons it might be marketable as a fund — could be faulty, however.

And while the indexers of the world are trying to look at sturdy stuff, they keep coming up with flimsy issues that deserve severe skepticism.

“Active or passive doesn’t mean as much as it once did,” explained Redding. “At this point, what matters is what went into the construction of the index and how well that can be brought to market in an investable product. Clearly, not every index idea is a good one, and neither is every index fund, so investors need to know that indexing alone doesn’t guarantee them good results.”