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The Weighting Game, and Other Puzzles of Indexing

Our experts discuss the state of passive investing.

John Rekenthaler, 02/22/2011

This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription here.

If we had hosted a panel discussion about active and passive investing 15 years ago, we would have titled it: "Indexing, Does It Make Sense, and If So, Why?" The burden of proof would have lain at the feet of the indexers. That's not the case anymore. The indexing community has built a compelling case in favor of the strategy, arguing that low costs, tax efficiency, and low turnover increase the odds that passive investments will outperform active vehicles. Investors have responded in droves.

To discuss the growth of passive investing, where it stands today, and whether investors, who now have immediate access to hundreds of different types of indexes, are benefiting, we invited two academics and one practitioner to participate in the Morningstar Conversation. Lubos Pastor and John Heaton are professors of finance at the University of Chicago Booth School of Business. They both helped develop the new CRSP family of indexes, which will debut this year, under the auspices of Chicago Booth's Center for Research in Security Prices. John Montgomery develops quantitative models to manage mutual funds for Bridgeway Capital Management, a firm he founded in 1993. The conversation was held Dec. 20 and has been edited for clarity and length.

John Rekenthaler: Now that indexing is accepted as a standard way of investing, is there any place where it shouldn't be accepted?

John Montgomery: From a practitioner's standpoint, where the case for indexing becomes less clear is in less-liquid markets. Bridgeway launched a fund in 1997 called the Ultra-Small Company Index Fund. About five years later, we took index out of the name so we didn't have to follow the quarterly rebalancing of our primary market benchmark. The same issue probably would be true in small emerging-markets stocks--anywhere liquidity is an issue.

Lubos Pastor: Just think about the S&P 500 or Russell 2000 reconstitutions. These are all events in which index managers and index investors lose money. Imagine a scenario in which half of the world does indexing with respect to the same index, and half of the world are active managers who do nothing but exploit the reconstitution effects. In a world like that, passive would be active, because the passive managers would have to reconstitute. They'd all have price impact in the same direction, and that would be exploited by the active managers on the other side. It is possible to cook up scenarios like this in which indexing wouldn't work as well as active management, but I think it's a little far-fetched.

Minimizing Reconstitution Effect
Rekenthaler: Lubos, you've been involved with the new CRSP indexes that are coming out. Are reconstitution effects something that you've been addressing in your new set of indexes?

Pastor: Yes. John Heaton and I have been involved in the design of the CRSP indexes, which will soon be in a position to compete with the Russell and S&P indexes. We've paid a lot of attention to reconstitution effects and to the migration of securities from one index to another. We're trying to minimize the transaction costs that John was talking about.

is vice president of research for Morningstar.

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