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Jordan Doyle and Genevieve Hayman: The Rise of Index-Based Strategies
00:28:23
Join as Jordan Doyle and Genevieve Hayman discuss their recent report, "Smart Beta, Direct Indexing, and Index-Based Investment Strategies." The conversation explores the historical context and substantial growth of index investing, highlighting the...
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A
Get ready for cfa Institute Live 2025 with free power packed webinars designed to inspire and inform. Led by industry experts, these concise sessions tackle game changing topics like how AI is transforming investment strategies in emerging markets. Don't just show up, show up ready. Gain the insights you need to drive meaningful conversations this May in Chicago. Claim your spot now@cfainstitute.org Foreign.
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B
Welcome to the Enterprising Investor, the flagship investment podcast for CFA Institute. I'm Mike Wahlberg and today we're heading into the gray zone between passive management and active. For many years it was fairly easy to identify a strategy as one or the other. Either you were buying the market through a passive fund that tracked a major market, or you threw your lot in with an active manager who promised to buy the good stocks and sidestep or even short the bad ones. As index strategies have matured, however, the gray zone has widened. We're going to talk to two research affiliates of CFA Institute's Research and Policy center today, Genevieve Heyman and Jordan Doyle, who recently published the white paper Smart Beta Direct Indexing and Index Based Strategies. Jordan holds a Master of Science and Finance from George Mason University and Genevieve is a PhD candidate at Georgetown with Masters from both George Mason and University College Dublin. I'm hopeful they can help clarify how we should be thinking about these strategies, what they are, and how we as an industry should look to incorporate and manage their use in client portfolios. Welcome to the show.
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A
Thanks for having us, Mike.
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C
Yeah, thank you. It's great to be here.
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B
So I want to trace index investing through the history that you wrote about in the paper because I actually find it quite fascinating. But first I wonder if you could give us a sense of the numbers that we're dealing with here in terms of market size and growth of index ETFs and mutual funds.
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A
Yeah, so we've seen substantial growth over the past few decades. Overall global TNA for index mutual funds and ETFs grew from just over that's.
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B
That'S total net assets.
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A
It just grew from just over $2 trillion a decade ago to almost 12 trillion at the end of 2023. So that's pretty substantial growth in a short time. Spanish and this growth we find is is largely driven by US equity funds which landed at around 8 trillion at the end of 2023 compared to non US domiciled equity index funds which was just over 4 trillion at the end of 2023. So really driven by the US equity market. And it's worth noting, if I may, that Our results are consistent with another recently released CFA Institute report by Mark Ranganam and Kenneth Blay. They have a paper called Beyond Active and Passive Investing and that paper offers a really insightful in depth comparison of markets and fund groupings. So if you're interested in going into the nitty gritty details, I suggest that paper is really fantastic in that area. So it's, it's worth noting that, and I don't know if I, I can go into detail about this at the moment, but I think going into the rise in index funds is really fueled by the introduction of ETFs into the market. Right. So the, the first dabble with ETF products was in 1990 with the Toronto Index Participation Shares or TIPS. I don't know if Mike being Canadian, you are familiar with that.
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B
Yeah, it was, it was pretty short lived though, right? Back in the day.
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A
Yeah, yeah, that's it. Yeah. So actually most people, what they, what they really identify as the kind of, kind of flagship ETF was Spider the Fighter S&P 500 ETF in 1993. And so ETFs have really kind of fueled this rise in index investing over, you know, the past decades. Around 70% of global equity ETFs remain passive as opposed to active. And that stayed pretty constant throughout the past decade according to our research.
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B
Yeah, I thought that was interesting that. Yeah, you showed that one chart that, yeah, it tracks the percentage of total represented by passive and it's fallen slightly over the last few years. So you talk about ETFs there and you know, the granddaddy of that is obviously John Bogle over at Vanguard. He wasn't the first into the market. But I wonder if you could talk about really quickly just about the history of kind of how passive got going because it didn't start we know him from the 70s, but it actually went back even further before that. And there's a cool anecdote on the early sort of opposition to passive investing that I'd love for you to tell.
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A
Really we can think about two things. The theoretical foundations which are really started in around the 1950s with of course Harry Markowitz's dissertation that became modern portfolio theory and where, you know, we get this idea for diversification, we get the idea that efficient portfolios minimize risk given a level of return or maximize returns for a given level of risk. Right. So there's this risk return trade off and then into, you know, the capital asset pricing model where you know, asset risk premiums are driven by its beta or the sensitivity of that asset's returns to the market return. And so these are kind of the theoretical foundations of what becomes this smart beta and those kinds of products.
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B
But just a quick, just to clarify there on for Genevieve, in terms of the importance to passive investing.
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A
Yeah.
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B
That switch in perspective among finance professionals from just focusing on return to thinking about risk highlighted the importance of diversification. And that's effectively, as I understood, why you started to see the rise in popularity of these passive strategies. Is that accurate?
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A
Exactly. Yeah. So it really became a strategy that shifted away from looking at, you know, individual securities, individual firms, to market level analyses. And so that's important, obviously, for index investing in general. In terms of the historical background of index investing, we can kind of turn to two fun examples of this kind of the beginnings of an active passive debate. And so in 1960, in the financial Analyst Journal, there was this paper by Renshawn Feldstein where they made the case for an unmanaged investment company. And in it they really proposed the idea that active funds may not reliably outperform the average. And they questioned whether they would actually be worth the costs. And of course, this was not taken up too well by the investment industry overall. It was largely dismissed. You know, and active mutual funds at the time continued to really thrive. And to the extent that, you know, not too long later, there was another paper by a guy, John B. Armstrong at Wellington Management Company and he really argued in defense of active mutual funds, saying that in general, they have met the test of time trying to rebuttal this original paper from 1960. And he won awards for that paper. And it was, it was well received within the field. We all know Vanguard, led by John C. Bogle, he created the first index fund available to retail investors. And the plot twist is that John C. Bogled turned out to be John B. Armstrong, who wrote that paper in, in defense of active mutual funds. He was using a pen name, John B. Armstrong, the John C. Bogle that we have known today as kind of the pioneering force of index investing, really, you know, played, played a role as well in this shift, but also maybe not in the way that we might think at the start.
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B
Yeah, it's amazing that he was one of the most vocal and well heard critics at the beginning under his pen name. I thought that was a really interesting twist in the story, one that I hadn't heard before. So let's talk a bit about the development of standard indices. We're getting towards alternative indexes. Most of us know the pros of, you know, say, a market Cap weighted index. You know, you get the diversification, you get the low cost, you get transparency. But what are a couple of the risks or problems that come with a traditional like S&P 500 market cap weighted index? Maybe Jordan, you can handle that one.
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C
Yes. So one of the biggest risks that comes with those market capitalization weighted indexes such as The S&P 500 is the potential for high concentration in some of those underlying constituents. Maybe the top 10 or 20 holdings in the index have the potential as they continue to increase in value to make up a large percent of the index. And it's kind of been one of the drivers or one of I guess the things that pushed investors to kind of look towards alternatively weighted indexes.
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B
So let's talk about alternative indexes a little bit. So switch gears here. And you've seen this evolution over time out of these traditional indexes. For, you know, some of these reasons you've got the concentration, risk and others. These are essentially structured to gain specific exposures to various different, I'm going to call them factors. Maybe it's a little early to use that word for this, but you talk about, you know, fundamentally weighted indices equally weighted, which obviously gives you a better exposure to small cap than you'd get from a, a market cap weighted one sort of minimum volatility weighted ones efficiently weighted. So looking at their Sharpe ratio and you know, giving higher weights to those and then what you call factor weighted, which is according to one or more factors across the spectrum. And we'll talk again about factors in a minute here. I want to take a little sort of side note here to, to just talk about one stat in here that I found astounding, which is that there are 3.3 million indexes globally, which is 70 times the number of traded stocks. And I actually wrote in the column of my, my version of this paper, and you got to this conclusion later, which is basically that these stocks are being cut and recut dozens and dozens of times. So it seems that the problem has been reversed. This idea that instead of choosing the best stock within an index, you're now trying to choose the best index that might hold that stock. It's kind of turned the problem on its head. Can you talk a bit about that? Just that dynamic that, you know, potential sort of movement from the analyst role from identifying good stocks to identifying good indexes. Maybe Jenny, maybe you can take that one.
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A
Absolutely. So this is a really important point, I think that comes out of the paper is this idea that what is active management, right? And at the end of the day, if you're thinking about it just generally in terms of making active decisions that impact the return of investor portfolios, then this is undeniably a form of active management. Right? As you say, selecting which indexes, which combinations of indexes should index. Investment funds rather, should be included within a portfolio. And so you're right, it does replace the kind of active management side of selecting underlying securities to invest in to, you know, diversify a portfolio to selecting indices to track within a given portfolio. And so I think we can think about both the proliferation of factors, but also just in general the proliferation of indices. Another paper analyzed 897 US indices and found that there was a lot of heterogeneity in methodologies that were claiming to capture the same strategies. Right. So they're. There's a concern there that we're not only mixing and matching different factors and weighting strategies, but we're also doing so in a way that doesn't necessarily pursue returns or the kind of end result that we would necessarily like, that there's an incentive to create a new index and say it offers all of these new and unique benefits. But at the same time, I think there's a question of, okay, well, where do we draw the line and say, okay, well, we're really testing whether or not these are contributing to the portfolio in the way that we say that they are.
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B
So I guess that's the question that I have is how do we assess these things apples to apples to one another? Because if they're trying to capture different elements and if they're not standalone strategies, maybe you're adding. And we'll get into smart Beta. You're wanting to get a certain factor exposure that will maybe augment your performance profile of your portfolio. How do you go through those 3 million indexes and decide what's good? I mean, is it an absolute efficiency ratio or like, how do you think about that if you don't have a single benchmark for them to then be compared against?
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A
I'm not sure I have a good answer for you in terms of, you know, what methodology you should use to, you know, assess a particular index, benchmark index compared to another one. But I do think it's relevant. And, and in our report, we talk about benchmark regulation, and that's something that has, is pretty well established in, in Europe, I'd say in the eu, but is relatively new in other markets. And I think having benchmark regulations that can help guide the construction of these indices can help to alleviate some of the concerns at least that for instance, there's, there's a lack of transparency or that there are certain conflicts of interests that might challenge the ultimately the performance of funds that are trying to use that index. And so I'm not sure, you know, I don't want to say that, oh, there's something inherently wrong in having a lot of indices, but there's definitely something wrong in having a lot of indices that have certain issues or these sort of conflicts within them. And so I think having regulations around that is needed. Yeah.
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B
Okay, let's, let's move on to Smart Beta. Obviously it is gaining an exposure to one of the six. You know, there's six main factors and it can be any factor really. I mean the main ones we generally tend to talk about value, size, momentum, volatility, dividend yield and quality, sort of the ones that tend to get most airtime. But I wonder if you could just give us a, an overview of what Smart Beta is and what the difference is from factor investing.
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C
Yeah, so the definition of Smart Beta has actually kind of evolved over the years. So originally this term was kind of understood to mean defined specifically fundamental weighting strategies and since then has evolved to define any weighting methodology that deviates from market cap weighting. So that could include all the other alternative weighting strategies such as equal weighting, volatility weighting, factor weighting, efficiency weighted. So the term has evolved over the years to include basically all those alternative weighting strategies. And I guess if we think about what Smart Beta actually is in terms of the characteristics of the investment, These smart beta ETFs or other smart Beta products tend to be rules based and transparent. So they have kind of characteristics of traditional passive management. If you think of like the high transparency and they kind of follow the rules based approach to tracking an index. But they also do have some characteristics of active management as well, such as the active decisions involved in selecting factors to gain exposure to or identifying a waiting methodology or security selection. So it kind of combines these characteristics of both traditional passive management but also active management. So it's just, it's kind of one of those interesting blends between the two. And these products typically are long only products and again we've talked about, they provide factor exposure, but they tend to be kind of more of a static factor exposure. So rather than kind of overweighting certain factors or underweighting others, Smart Beta products tend to provide more of a static or constant exposure to these different factors. But I think an interesting to note about, an interesting thing to note about smart beta ETFs is that even though they can provide that static factor exposure to these alternative weighted indexes, because these products are ultimately built to track alternatively weighted indexes rather than market cap indexes. So they provide the static factor exposure to those types of indexes. But relative to a traditional market market cap index, it would kind of be a built in factor tilt because if it's tracking an equal weighted index that naturally provides greater exposure to small cap stocks and the size factor relative to market cap index, it would be an overweight to the size factor. So it's, you know, it's kind of relative to the index that the Smart Beta product is tracking or providing exposure to. But I guess generally if you think about how these products naturally will track an alternatively weighted index, then they, they'll provide static factor exposure.
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B
Right. And, and the, and the smart beta products are derived from an existing index, whereas the factor investing is not constrained by that as I understand it. Is that right?
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C
Yes, that's correct. And factor investing also has a little bit more flexibility, I guess, to take in addition to long positions, they can also take short positions, whereas smart beta products typically are long only products. So factor investing is kind of the broader term and can encompass smart beta ETFs and other smart beta products.
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B
So one of the things I thought was quite interesting, you incorporated looks like Kahn from 2018, a framework where he breaks down, you know, listeners, this podcast will be well acquainted with the idea of breaking down total return into, you know, beta or your index exposure and then alpha, what you added above that benchmark. But you break down the alpha piece effectively into you got your benchmark return and then your, your active return is comprised of sort of pure alpha in the way that we, you know, we all know it, picking stocks, you know, depending if you have a fundamental layer, but then also this, this return from exposure to a smart beta factor. So we're going to come to this in a little while because you use that as a basis for the framework for understanding where on a continuum of like pure passive to pure active. A certain strategy might be Smart Beta. As I understand it through your work here, it comprises a piece of, you know, how active a strategy is. So again it's benchmark performance plus your pure alpha fundamental activities, plus this return from, from smart Beta. So let's, let's move on here. In the interest of time, we've got another sort of key area that you guys focused on was direct indexing. Maybe you can take us through kind of like what the sources of Demand for direct indexing, maybe in brief, but then just explain kind of what that is and then maybe some of the key pros and cons of that strategy.
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C
Yeah, yeah, no problem. So direct indexing is one of these newer strategies that's become more popular, especially in recent years. And one of the interesting things about this strategy is that originally it was primarily available to institutional and high net worth clients because of the high cost associated with the strategy. But recently, due to these technical technological advancements and especially the increased capabilities of being able to trade fractional shares, it's become a lot more accessible to retail investors and the cost of it has decreased by a significant amount. And so the strategy consists of originally buying all the individual constituents and index and holding those securities in a separately managed account, which a separately managed account just allows basically for the individual purchase and sale of individual securities. So kind of as the baseline for the strategy, an investment advisor will purchase the underlying securities in an index for a specific investor, and then based on that investor's preferences, they can underweight or overweight certain securities, or even overweight or underweight certain asset classes and basically tailor it to that individual investor. And so this is one of those strategies where it could be different for every investor, depending on that investor specific circumstances or preferences. And so this strategy also kind of like what we saw with The Smart Beta ETFs or Smart Beta products in general, combine some characteristics of both traditional passive management and also active management. So, and it really again just depends on the specific investor because for some investors, the strategy might be holding all the constituents of the S&P 500 at those specific weights in the index. Whereas for another investor, they might overweight certain securities or underweight others, depending on their preferences. But the investment advisor is constrained to investing only in the securities and index. I guess if we think about some of the benefits with this flexibility and being able to personalize it for investors would probably be one of the main benefits for the strategy. Whereas I guess one of the disadvantages is because it consists of so many purchases and sales of securities relative to just buying one mutual fund or one etf, it requires a lot more monitoring and rebalancing of the portfolio to kind of make sure the portfolio continues to align with the investor's interest.
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B
Yeah, and an example of sort of this personalization that when we talk about taxes, you know, obviously for individual taxable investors, you can sort of manage around that. And the one other example you used there was on esg. So you'd be able to, you know, do a Tilt or an exclusion on certain industries, if you wanted to reflect that. One question that I had on this, and is it an interesting idea, this direct investing? I guess the one thing that pops out to me and maybe, maybe also in the mind of others listening, is if the active decisions are being made by, at the advisor level, maybe an Advisor who has 50 or 100 or 200 clients, all with different needs and risk profiles, and maybe doesn't do active management as a full time job. So it's not as front of mind as it might be for someone who is, say, you know, a quant analyst or a fundamental analyst. I wonder how the return streams will look for these strategies and when they're, when it's being spread thin by, by folks who don't do this, usually on a full time basis. It's a curious idea. I don't know, I don't know how that'll, how to look.
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A
Maybe one thing that's worth mentioning, and it's not going to be an answer to that or a response to that, Mike, but it's worth mentioning, I think that much of these products have been driven by the rise in demand for personalized strategies from investors. Right. So of course that doesn't guarantee a better return, a better outcome, but definitely that's something that we've seen within, across various markets after, you know, surveying, performing, you know, CFA investor surveys, we see demand for personalized products. And so this space of smart beta products, of direct indexing, these are much in response to that consumer demand. Right. Or personalized strategies. And I think that's why you see interest in them besides just, you know, the potential to, to generate excess returns. And so it's worth highlighting.
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B
Yeah. So maybe, maybe the answer is the trade off that clients may be willing to make against maximizing risk adjusted returns if they are able to reflect their own personal view in their portfolio. So fair enough. So let's turn now to just talking about the framework that you guys developed that to help us understand and navigate that gray zone. Could you just talk us through the kind of the four levels, how you're categorizing them and where each of these different items would live. And maybe that can help us kind of understand how to think about whether something is passive or active.
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C
Yeah. So I guess if you look at the framework, you can classify these products along three different dimensions, one based on strategy, another based on returns, and then also based on the level of discretion. And so if you look at the strategy, it can range from pure index funds on the far left, all the way to on the far right, fully active funds that are completely unconstrained. And so you can also think of this as funds ranging from an active share of 0% to an active share of 100%, where active share is defined as the difference in the fund holdings relative to the holdings in the benchmark. So if a fund has a zero active share, that fund will have the exact same holdings as the benchmark held at the same weights as the benchmark relative to 100% active share. It's a completely active fund with holdings that completely differ from the benchmark and none of the same weights either. And then in the middle you kind of have these enhanced indexing strategies. The long only hands index funds are constrained to only taking long positions and because of that will provide the static factor exposure. Whereas the long short enhanced index funds are very similar to the long only funds but have the added ability to use leverage to take short positions and because of that can basically provide non static exposure to some of those factors. I guess going down to the returns based row which classifies these funds based on the sources of return, on the far left would be funds that only provide the market cap weighted benchmark return. And these would be funds that only provide basically systematic risk exposure or beta and no return. In addition to that, all the way to the far right would be funds that provide the market cap weighted benchmark return plus the full active return too. And then in the middle kind of associated with those long only enhanced index funds, those funds again because they're constrained to only taking long positions, would only provide the return from static factor exposure in addition to the market cap benchmark return. Whereas the long short enhanced index funds would provide that static factor exposure return, but also the added ability to provide returns from smart beta timing or non static factor exposure.
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B
And for those keeping score at home there's these are called level 1, 2, 3 and 4. I actually encourage you if you do check out the article, it's exhibit 10 there smart beta in your categorization fits in level two. And then direct investing, depending on how much deviation from the benchmark you you take can be sort of a 1, 2 or 3. So those kind of fit in the, you know, medium to high levels of active. And smart beta is kind of one step up from from the most pure. Play passive. Now just in the interest of time here, I wonder if you can talk just quickly about the takeaways for in terms of public policy that that you make recommendations you make to policymakers and to firms.
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A
I'll jump in Here. So, yeah, we can kind of summarize what our policy recommendations are in the sense of they're around cultivating transparency and informing investors. Right. So some of that's through, as I mentioned, benchmarking regulation and incorporating that into the benchmark creation process and licensing process, but also in terms of all the way down through the asset management firms who develop products on top of these benchmark indices and then as they market those products to the end investor, right, making sure that investors know, you know, what they're getting with these products. And in particular, I think one of the things that we've really tried to emphasize is that I think that because there's this traditional passive active divide, right, where they're seen as two separate categories, there might be some misunderstanding or de emphasis on all of the kind of active decisions that go into creating index based products. And so we can think about that. Even from the creation of an index, there are index providers have to determine, you know, how to develop rules to determine whether or not certain securities are included in an index or not, as well as, you know, weighting strategies and methodologies. And then those can be updated based on committees within the index provider. You know, as you add Smart Beta on top of that, as you add direct indexing on top of that, you know, you increase the number of decisions that get made, you know, which factors to select, which you know, specific investor decisions you're going to incorporate into the portfolio. With direct indexing, it's important to recognize that just because it's not active management in the traditional sense, there are still, it doesn't mean that there aren't, you know, active decisions being made throughout the process. And so, yeah, we found it particularly hard sometimes to find some of these methodologies and strategies that were used. So that's why we, we kind of advocate for that increased transparency and distribution of information.
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B
In that regard, I've been speaking today with Genevieve Heyman and Jordan Doyle, research affiliates of CFA Institute's Research and Policy center, and authors of Smart Beta, Direct Indexing and Index Based Strategy. Genevieve Jordan, thanks so much for coming on the show today.
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A
Thank you, Mike.
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C
Thank you.
- [28:31]
B
I'm Mike Wahlberg and this is me, the enterprising investor.