Nick Dewhirst looks at the history of index development and how it has affected approaches to investment through the years
Nick Dewhirst, CEO, INvestors-routemap.co.uk
If a fund manager beats an index for any length of time, we fete him as a genius, but is that really so? As in any field of intellectual activity, there is a great deal more to the construction of indices than an outsider may suspect.
Having built some index families myself, I can confirm that there is often less than meets the eye to such genius. Here, therefore, is a short history of index development, which shows how the industry has progressively refined the concept of fairness as understanding and computing power have increased over the years.
In the beginning, Dow Jones begat an index of 30 industrial shares. As publishers of the leading financial journal a century ago, they needed a short-hand way of describing the overall direction of share prices on Wall Street. In London, the Financial Times later copied them by launching their own index of 30 leading UK firms.
In the days when calculations were done manually, the key consideration was simplicity: 30 shares were considered a sufficient number than no one company would unduly distort the performance of the average. As it was necessary to multiply individual share prices to calculate percentage changes, it seemed simplest also to multiply these together when working out the average. Unfortunately, that can cause distortions as companies with high share prices have disproportionate impact on such averages.
With the passage of time, the original selection of firms became unrepresentative due to bankruptcies, mergers and the growth of new industries, so the publishers revised the list of constituents from time to time. The original list of 1886 was first revised in 1894, and the policy of occasional rebasing continues, such that today, of the original constituents, only General Electric remains.
Although not the purpose for which it was designed, it was only natural to compare performance of actual portfolios with their index. The combination of these two effects made the index easy to beat because companies with high share prices perform worse than average, for the simple reason that they are often overpriced.
If new industries are recognised when their leader is among the top 30 and there is a lag of some years before the next review, it is often the case that the stock market has already discounted much of the growth potential. Microsoft is a classic case. It only entered the index in November 1999 at $48 after it had risen from less than $0.01 in its two-decade history. It briefly touched $60 at the peak of the bubble a couple of months later and now languishes around $25.
While the effect may have been well known to insiders, if less well advertised to investors, there was little that could be done about it till the advent of large computers. As an independent research firm, Standard & Poor's was the first to make the investment needed to calculate an index broadly representative of the whole market, by including all of the 500 largest companies.
At the same time, they eradicated the downward bias by calculating on an arithmetic rather than geometric basis, that is, adding together the individual changes and weighting them by market capitalisation, creating the first modern index. Again the approach was copied by the Financial Times when it launched the FT Actuaries All Share Index.
The first graph shows the older Dow index compared with the broad-based S&P index. For the first 25 years the Dow underperformed by 40%, almost 1%pa. Given the bell curve distribution of fund performance, that would have a disproportionate effect in making average fund managers appear above average.
Other biases have since contributed to substantial divergence, so that percentage changes in the Dow index are a poor indication of overall market trends. While this index is not used professionally by performance actuaries, it is still widely quoted in the media, so may mislead the wider public.
In 1961, Value Line, a rival to S&P, launched an even more ambitious index covering approximately 1,700 shares in its research universe, but regrettably chose to calculate it in the geometric method so that the smaller companies it researched could be compared with Dow Jones' index of market leaders.
In 1985, they also began calculating on an arithmetic basis but to replicate the actual use of its service by individual investors chose to do so on the basis of investing equal amounts in every share, rather than by market capitalisation.
The effect can be dramatic, as shown in the graph of the relative performance of different smaller caps indices compared with the S&P 500. In addition to the two Value Line indices of about 1,700 shares this includes S&P's own indices of 400 mid cap and 600 small cap shares and the Russell 2000, which includes all companies ranked 1,000 to 3,000 by capitalisation.
While the overall trends are broadly similar, the cumulative difference can become substantial, which matters when measuring fund performance. Even between the similarly calculated capitalisation weighted indices, the difference between Russell and S&P amounts to as much as 3.3% a year. So for managers of smaller cap funds, Russell is much easier to beat than S&P.
However, it is the difference between the Value Line indices that is truly staggering. According to my calculations, it amounts to 12.8%pa compound.
Which is fairer - capitalisation or equal weighting? That is a function of size. Large pension funds simply cannot jump into or out of the stock market at the flick of a switch. It may take days, weeks or even months for the largest to effect even a partial reduction in their equity weightings, so capitalisation weighted indices are appropriate for them.
However, for the purposes of investment advisers, individual investors and trustees of smaller funds, equal weighting is more appropriate as it is also for focus funds marketed to them. This is because diversification rather than replication should be their prime concern in managing their risks. It is the number of different holdings rather than their size that matters.
Dow Jones set up as basket of equally weighted stocks.
Negative is that high share prices can skew the index.
Firms with high share prices tend to be overpriced and perform poorly, so it is easy for a fund to outperform equally weighted index.
S&P 500 the next development, a market cap weighted index.
Market cap weighted tends to beat equally weighted.
Large pension funds have to follow market cap index, they are too big to do otherwise.
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