What is an Index?
27 Pages Posted: 12 Oct 2015
Date Written: October 12, 2015
Technological advances in telecommunications, securities exchanges, and algorithmic trading have facilitated a host of new investment products that resemble theme-based passive indexes but which depart from traditional market-cap-weighted portfolios. I propose broadening the definition of an index using a functional perspective — any portfolio strategy that satisfies three properties should be considered an index: (1) it is completely transparent; (2) it is investable; and (3) it is systematic, i.e., it is entirely rules-based and contains no judgment or unique investment skill. Portfolios satisfying these properties that are not market-cap-weighted are given a new name: “dynamic indexes.” This functional definition widens the universe of possibilities and, most importantly, decouples risk management from alpha generation. Passive strategies can and should be actively risk managed, and I provide a simple example of how this can be achieved. Dynamic indexes also create new challenges of which the most significant is backtest bias, and I conclude with a proposal for managing this risk.
Keywords: Index Funds, Indexation, Passive Investing, Smart Beta, Liquid Alternatives, Risk Management
JEL Classification: G11, G12
Suggested Citation: Suggested Citation