The Art of Streetplay

Sunday, December 18, 2005

Response to Gavekal's Indexation Article

Response to “How do we invest in this brave new world? Is indexing the answer?”by Charles and Louis-Vincent Gave and Anatole Kaletsky

Gavekal's article was quite thought provoking and very interesting, and revolved around a few central tenets.  One tenet is that the existence and rise of indexation will lead to more inefficiency in the market rather than less.  There were a few reasons.  One reason was that the increased importance of the index made the index the reference point for risk.  Another reason was that due to its being capitalization weighted, the purchase of the index led ones portfolio to be systematically overweighting the stocks which probabilistically speaking are the most overvalued, and vice versa.  It’s a relatively complicated article and there’s no way I can do it justice in one paragraph, so I recommend checking it out.  It is available to the public for free over here.

I just had two questions.

It seems an underlying assumption made in the paper is that “indexation” is and will be, primarily, investment in something which tracks a broader market segment like the S&P.  However might this be changing, albeit slowly, as more investors begin to see the investment appeal of ‘alternative’ indices?  Arnott’s indexation methodology is being implemented at PowerShares and Allianz.  Rydex is actively pursuing a number of innovative strategies.  Its S&P equal weight has a tinge of Arnott in it and has outperformed materially for a quite while, arguably not only because of its relative overweighting in small caps but also perhaps because of some degree of nuances due to its rebalancing. WisdomTree is supposedly coming to market with other innovative products.  Greenblatt at the Conference last week made a very compelling case for a strategy which could very easily be converted into an ETF product, and I would be highly surprised if it isn’t.  All of these products can be invested in by your typical individual investor.  I agree that to some degree these are untested concepts, but they are interesting trend in the ETF world, and one which might have implications many years down the road for those investors who don’t have the time to be effective price choosers in the market mechanism.  

Secondly, at that point it could be of value to take a second look at how investment professionals add value to the market. They are compensated for efficiently pricing stocks so that capital is more properly allocated to those who need and deserve it.  If alternative indexes like Greenblatt’s become very popular, it’s as if a sliver of alpha has left the system for a mere handful of basis points.  It would put mutual funds in an awkward position because the relative importance of their benchmark is diminishing, and yet they are forced to remain chained to its fluctuations.  This could have a crippling effect on them and their performance.  And hedge funds would then have to find increasingly innovative ways to generate the alpha their investors are looking for in a seemingly shrunken opportunity set.  Under this paradigm, money would begin to flow, probably slowly at the start, out of mutual funds and the market would evolve into how I think it probably should be—ETFs and professional money managers (hedge funds), focused on absolute returns and on products all up and down the risk spectrum in all shapes and sizes to accommodate the risk preferences and hedging needs to better serve their investors.  While mutual funds have a leg up organizationally and operationally because of their firm entrenchment in various retirement programs, I am optimistic that market efficiency will overcome this if an ETF which charges a mere handful of basis points can do all of what the mutual fund does but at a far cheaper price.  We can somewhat see it coming already, with the rise of ETF’s which are much more friendly to employees at companies—ETF’s which are actively trying to gain ground in the various channels which have traditionally been dominated by mutual funds.  It is in their best interests, and rightly so, to push as hard as they can into these channels to steal market share.  Given their structure, I believe they have a good shot at succeeding.  
Once again great article, I was just wondering what your thoughts are on these questions and thought they might be interesting.


  • ETFs have a number of advantages.

    Because they behave like stocks one can do short term timing to make or save a percent or two. For an index fund this is several years fees.

    One can easily time on a larger scale, buying sectors and the switching is easy.

    The bookkeeping is easy because one can buy a large variety of specific markets in the same account. Even funds with many choices like Vanguard don't offer specifics like Korea.

    Index funds do have an advantage of price averaging. If one is in for the long term then 300 a month into some broad index does work well. The ability to time is a theoretical strength, but for most investors it's a practical weakness.

    A number of funds do have well tought out philosophies and the capacity to implement them. If one can find such finds they will give great results. Of course most funds that attempt this get below index returns.

    I think ETFs provide a tool for a certain type of investor. For most people I think regular contributions into a broasd set of funds with periodic (once a year) rebalancing is probably the way to go. Over the long term the averages are good and this is a way to get them.

    By Anonymous Anonymous, at 3:32 PM  

  • Do you have more info on Greenblatt's research? What's his full name anyway? I've been interested in Fundamental Enhanced Indexes this year. I liked Arnott's paper, enjoyed O'Shaughnessy's revised edition of 'What Works on Wall Street' and was excited to hear about the PowerShares Value Line Timeliness Select ETF.

    But I've been trying to pick holes in my excitement about non-cap-weighted Fundamental Enhanced Indexing and my thinking now is tending towards equal weight funds.

    I don't know how to (or want to) predict the future efficacy of factors (Arnott, Fama/French), manager's performance, stock correlations (MPT anyone?) or anything (regressed/backtested or not) so I'll try to go super passive and going for broad diversification in efficient markets via equal weight indexes (I need to read more about this). Instead of hoping for Prescience, I'll go for Patience.

    I feel like I'm missing something quite big in my thinking but with everyone chasing the cherry on the cake that is Alpha, I'm quite happy with the cake itself and go for low maintenance Beta of efficient markets. I do believe in Alpha though, but if I'm paying a manager 1%, I want it to be for something else apart from easy access stocks. I want it to be for stuff that most investors can't get access to, like exclusive international Private Equity deals. Don't get me started on hedge funds though, I quite like Harry Kat's research on synthetic hedge fund returns. Mark Anson's paper 'Institutional Portfolio Management' is also interesting.

    This article made me think about whether Fundamental Enhanced Indexes were just Small-Cap Value funds.

    Alos have a look at Edhec's research. It's like drinking out of a fire hydrant.

    By Anonymous Orwellthatendswell, at 3:17 AM  

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