what stock indexes do

Stock indexes have two main functions:

1.  They provide information about how stocks in general are doing.  Part of this is that it’s nice to know, sort of like the weather. But that’s not all.  The broad stock market has an important role in macroeconomic forecasting.  In the US, the stock market is historically the most reliable leading indicator of economic activity.  Even in today’s world where half the market’s profits come from abroad, changes in stock market direction tend to accurately foretell changes in economic growth that occur around six months later.

2.  Indexes serve as measuring tools to assess the performance of professional money managers.  Three factors have made the role of benchmark increasingly important:

–the widespread rise, post-WWII, of pension plans for workers,

–The Employee Retirement Income Security Act (ERISA).  This Federal legislation, passed in 1974, set down strict standards for corporate stewardship of employee pension plans, and

–rising affluence, which has transformed stock market investing from the exclusive province of coupon-clipping bluebloods into an arena where middle-class Americans can, and do, participate.

academic research on active management

Most of the finance taught in universities is pure nonsense, in my view.  The real world is much more complex than professors realize.  Nevertheless, academics do do good empirical research studies.  One of their most devastating findings is that the typical professional, or “active” investment manager in the US routinely underperforms his benchmark index.  Almost no one outperforms after deducting the fees he charges for his services.   Ouch!  (As it turns out, my portfolios generally outperformed, but I usually ran portfolios that had large exposure to foreign markets–which are another story).

Once ERISA forced pension funds to pay attention, they quickly learned this lesson.

Hence the rise of index funds, which track very closely the performance of benchmark indexes like the S&P 500 and have extremely low costs.  That’s “low” in the sense of better performance than an active manager, at far less than 10% of the costs.

lots of index providers

Standard and Poors has a whole slew.  So does the Financial Times.  Pension consultant Frank Russell has a bunch, too.  And MSCI.

Why so many?  

–They’re profitable.  They’re also relatively easy to set up.  All you need is the money to hire a few quants and a giant computer.

–The first guy in collects the most assets.  Therefore, unless he really messes up, he should have the lowest costs.  And as a result of that, he should get the majority of new inflows.  So it’s much, much better to have an index fund product a little in advance of any demand.  Being late to the party is devastating.

they’re all a little bit different

The FT index for large-cap US stocks has somewhat different constituents from S&P’s;  both are different from Russell’s.  That’s to make it more expensive for large institutional clients, who may pay only a few basis points per year in fees, to switch among index fund providers.  So they can’t play one provider off against the others and bargain for lower fees.

More tomorrow.