I read some jaw-dropping research this week from Bernstein. The investment firm says there are now more than a million market indices worldwide. Yet, by contrast, there are only 43,000 quoted stocks across the globe.
This seems a bit nuts to me. It also underlines how obsessed the investment industry has become with benchmarks, and it highlights the amazing rise of smart beta. Don’t get me wrong, both benchmarks and smart beta have their virtues, but there are issues around Bernstein’s research that investors need to be aware of.
Let’s start with the numbers.
There are more than a million indices around the world and that number is growing ‘exponentially’ according to Bernstein. (Bernstein is using figures from S&P). Around 850,000 of the million indices are for equities, the rest are bonds and other assets.
We’re seeing exponential growth because the barriers to entry are low – it’s not that hard to create an index – and there appears to be plenty of demand.
Indices cover different regions and sectors but most importantly they now focus more and more on different investment factors such as size, value and momentum. Focusing on these factors is a big part of what we now call Smart beta investing. Now there aren’t anything like a million investment factors, but if you combine the factors in different ways, add in regions and sectors, as well as lots of different precise rules for each index, you can get to the million figure and higher.
The contrast between a million indices and 43,00 stocks is very striking, but even that 43,000 figure is arguably too high. There are 43,000 stocks out there, but Bernstein suggests that only around 3000 stocks are liquid and easy-to-trade worldwide.
What this means for active managers
Most active managers are pretty focused on their benchmark index. Every active fund has a benchmark and most funds use well-known indices such as the FTSE 100, the S&P (for US funds) and the Nikkei (for Japanese funds.) The idea is that an active fund should beat its benchmark more often than not and if the fund fails to do that regularly, the manager may get the chop.
The focus on benchmarking is good in one way, it’s pressuring active managers to do better than simple passive funds such as a FTSE 100 tracker, and it makes performance more transparent. On the downside, benchmarking pushes some managers towards ‘closet tracking’ where the fund’s portfolio isn’t that different from a passive fund tracking the benchmark.
The new(ish) threat to active managers is the rise of smart beta where passive funds steer clear of the well known ‘meat and potatoes’ indices and instead track more exotic indices that are often factor-based. And the explosion of indices highlights that smart beta threat. Perhaps an active fund that normally follows a value approach should be benchmarked against a value index? Or maybe two indices? So for a UK value fund, maybe the FTSE All-share along with the MSCI UK Value weighted index? If a ‘double-benchmark’ became standard practice, it’ll become even harder for active managers to justify their fees.
What this means for passive providers
On the passive side of things, Bernstein argues that the proliferation of indices just stresses that the passive investing is only partly passive. Yes, once you’ve decided to invest in the FTSE 100, you then put your money into a passive FTSE 100 ETF,and that ETF is 100% passive.
But the decision to put money into the Footsie is an active asset allocation decision. And it becomes all the more active if you consider investing in all the different regions of the world as well as all the different investment factors including value, size, momentum and low volatility.
This has interesting implications for the future of the asset management industry. If asset allocation is the active part of the investment process, that’s where the money is going to be. So who will grab that money and do the asset allocation work?
It could be traditional fund managers with their multi-manager funds (although these funds often invest in actively managed funds, which means you end up paying for two layers of active management.)
Or it could be wealth managers like Charles Stanley or 7 Investment Management. Both of these firms offer multi-asset funds as well as more bespoke services for individual clients. If you use an IFA, he/she may refer you onto a wealth manager to do this asset allocation work.
Another option is the robo-advisers such as Nutmeg or Scalable Capital.
Or, of course, you can make the asset allocation decisions yourself. It’s the most challenging option, but also the cheapest, and potentially the most fun. We’ve created a regular radio show to look at current asset allocation issues. The most recent show was on emerging markets.
One thing I’m clear about: awareness of asset allocation is rising and that can only continue if even more indices are created.