Redefining indexes to reflect reality

The investment industry should be constantly looking at the impact of technology on the status quo. Just because indexes have been defined as cap-weighted portfolios, doesn’t mean that can’t change. In fact, the evolution in portfolio management necessitates a change in thinking with regard to the definition of indexes, in particular so risk management can be decoupled from alpha generation. In a new paper that argues for a new definition of what constitutes an index, Andrew Lo, professor of finance at MIT Sloan School of Management pushes the boundaries by not only suggesting change, but by demonstrating a new functional definition for indexes and the benefits, and pitfalls, of doing so.

Technological advances in telecommunications, securities exchanges and algorithmic trading have facilitated a host of new investment products that resemble theme-based passive indexes but which depart from traditional market-cap-weighted portfolios.

Lo proposes broadening the definition of an index using a functional perspective. He says that any portfolio strategy that satisfies three properties should be considered an index:

(1) It is completely transparent

(2) It is investable

(3) It is systematic, or it is entirely rules-based and contains no judgment or unique investment skill.

He says that portfolios satisfying these properties that are not market-cap-weighted are given a new name: “dynamic indexes”.

“This functional definition widens the universe of possibilities and, most importantly, decouples risk management from alpha generation. Passive strategies can and should be actively risk managed, and I provide a simple example of how this can be achieved,” he says in the paper.

“Dynamic indexes also create new challenges of which the most significant is backtest bias, and I conclude with a proposal for managing this risk.”

Lo’s paper looks at a brief history of indexes and index funds, defines an index and looks at the separation of alpha, beta and sigma.

He says that indexes have evolved over time and today, indexes serve many purposes. In addition to their original function of information compression, indexes act as indicators of time-varying risk versus reward, and as a benchmark for performance evaluation, attribution and enhancements. And since the advent of the Capital Asset Pricing Model, indexes have been used to construct passive investment vehicles and as building blocks for portfolio management.

But, as Lo and many others have pointed out, the advent of “smart beta” need not be smart at all.

He says that the lack of risk management – or the fact “smart beta” is often accompanied by “dumb sigma” – is perhaps the greatest weakness of traditional passive investing.

“A new framework is needed for thinking about indexes, indexation, and the distinction between active and passive investing that reflects the new reality of technology-leveraged investing.

“The starting point for this new framework is to generalize the definition of a financial index by focusing on its basic function. If an index is to be used as a benchmark against which managers are judged, it must have three key characteristics: it is transparent, investable, and systematic.”

To access the full paper click here

What is an index?