Indexing's Brave New World

With an abundance of new passive products, it’s time to redefine index investing, argues MIT’s Andrew Lo.

Indexes are becoming more than just market-cap-weighted portfolios, according to a new report from MIT.

“A confluence of technological advances has caused tectonic shifts in the financial landscape, creating winners and losers overnight.”With new passive investment products continuing to emerge, Sloan Professor of Finance Andrew Lo proposed broadening the definition of an index to include “dynamic indexes” such as smart beta strategies.

Indexes, he argued, should include any portfolio strategy that is completely transparent, investable, and rules-based. Dynamic indexes are any portfolio that fits this definition but is not market-cap weighted.

Instead, the dynamic indexes are weighted according to other factors—and not just value or momentum, according to Lo’s definition. Target-date and life-cycle funds, for example, change their asset allocations as they approach target dates, while hedge fund replication strategies replicate the betas of entire classes of hedge funds.

The distinction is important, according to Lo, because dynamic indexes may contain more “subtle” risks, such as tail, illiquidity, or credit risk.

“Passive investing need not, and should not, imply passive risk taking, as it currently does,” Lo wrote. “If used properly, dynamic indexes can greatly benefit both investors and portfolio managers by allowing them to construct more highly customized portfolios that can achieve long-run investment objectives by managing short-run risks more effectively.”

But while the new brand of indexes can be used to an investor’s advantage, they also pose new challenges: The sheer number of financial products available requires greater education and training to evaluate potential risks and returns.

More importantly, the rise of smart beta leaves investors and portfolio managers exposed to misleading backtest bias.

“The number of new products is growing rapidly, and because, by definition, new products do not have live track records, estimates of their performance can only be based on simulated returns and are, therefore, noisier than for more-established products,” Lo wrote.

“Because simulations are, for many of these new products, the only way investors can develop intuition for the products’ risk/return profiles, decisions tend to rely much more heavily on biased performance statistics,” he continued.

When investing in smart beta indexes, therefore, Lo recommended treating all investment performance records with a “healthy dose of skepticism,” and using additional information and live-out-sample experiments to distinguish between luck and skill.

“A confluence of technological advances has caused tectonic shifts in the financial landscape, creating winners and losers overnight,” Lo concluded. “The winners are technology-savvy investors who understand their own risk preferences and financial objectives, and can appreciate the full spectrum of risks and rewards offered by today’s dizzying array of smart-beta and index products.”

Lo’s paper, “What is an Index?”, can be downloaded from SSRN.

Related: The True Cost of Active Management & Smart Beta’s Takeover