Wolf in Sheep's Clothing: The Active Investment Strategies Behind Index Performance

Abstract

This paper argues that the commonly used market indices imply forms of active investment management in disguise. The selection and rebalancing rules make these indices highly exclusive and dynamic regarding their underlying components and significantly bias their performance. Any passive investment tracking these indices turns into an active strategy characterised by market timing and state-dependent performance. Evidence is provided that exclusive indices outperform (underperform) more inclusive peer indices over upward (downward) markets. The constitution and maintenance rules of exclusive indices correspond to a set of active trading and investment rules similar to momentum and stop-loss strategies.

Keywords: index performance, active / passive investment management, momentum strategies, index constituents; selection and rebalancing rules; performance measurement; "buy-and-hold" strategy

JEL Classification: G11