A lot of water has flown under the bridge since the concept of stock indexing came in vogue. The entire world keeps tabs on the index numbers to understand various economies. Simultaneously, there is an explosive growth in the amounts of funds invested in the Indexes that have proven to be highly popular investment vehicles.
Having said this, what makes me revisit this topic? And what I have understood that I wish to share with readers? Let us begin at the very beginning. When, in 1896, Charles Dow launched the ubiquitous Dow Jones Index - both for Transportation and Industrial sectors - the idea was to let people know the current value of prominent stocks traded in the New York Stock Exchange. By knowing this number, investors were generally able to identify the trends of whether the market was going up or down and correlate the same with general business environment. In a nutshell, the original purpose of publishing a stock index was to let the investors/traders know how the market is behaving. Since this index was, and still is, a price-weighted index, the movement of prices of the constituents had direct correlation with the index value. Of late, market-capitalization based indexes have flooded the market and all these are tracking either the entire market, or some sector, or a bunch of economies or maybe even the color of the constituent stocks' logos. The utility of market-capitalization based index stems from the fact that it represents the value of underlying stocks instead of only prices. Also, when the constituents of an index increase to gigantic proportions, such as the Russell 3000 or Wilshire 5000, then its claims of representing the entire market get a very sound footing. Now as a market participant, why am I interested in the indexes? I can have two purposes today, unlike yesterday when I used to only track the market. Today I am interested in investing in the indexes too. I have plethora of options investing in Index Funds, Index Derivatives, Index ETFs and Index what-nots. The dilemma starts here, really. When I want to invest in an Index Fund, what should I look for? Should I look for an index which gives me better returns or an index which represents the market and is accepted by wise men as a benchmark? I think the idea should be to have separate indexes for market tracking and for investment. Why should one index, which is treated as the best barometer of the market, find itself eligible as an investment vehicle? Both the activities are like chalk and cheese. I shall invest in an Index based on my investment theories of having highest returns with lowest possible risks. I may not be interested in what the market tracking index is doing. In fact, my idea will be to beat the market tracking index constantly, which is definitely possible due to less than fully efficient markets. Not going into detail dissecting the theory of efficient markets itself, suffice it to say that each market has its fair share of insider information, resources, speculators and wildly different perceptions of future income streams to ensure that the stock price (or market value – based on this price) always remains adrift of the factual enterprise value. To further stress the difference in index usability, an example is in order. When a superstore advertises the floor space available, the merchandise, the warehouses, the discount offers, it feels nice to know about the store and we make a mental note of it. But when it comes to buying from the store, we do not necessarily buy the largest selling, high discount items – say a fabulous bedroom package when I know I am not even able to walk in my bedroom with two hands stretched sideways! What I am interested in the store is my monthly groceries and the quality they are providing and at what price. I would go to the store to buy only groceries – the things I need. Though I will probably repeat that, it is nice and informative to know about the store, its merchandise, its stockpiles and its discount schemes. Why then do people keep investing in market tracking indexes where they know that the returns are not necessarily going to be the way they want? Why would they want to invest in a fabulous bedroom package when they only need bread and cereals of highest quality? Let us change our track a bit. There is always a significant (and usually successful) class of investors in every market who invest in portfolios carefully chosen by having fundamentally better stocks as constituents. The choice of fundamentals can be left at their discretion and for their wisdom. They always find opportunity to invest in those stocks and generate returns which usually are better than the unfortunate market tracker can provide. What is important to note here is there is a definite need to distinguish very clearly the types of index based on its utility. Whether you want to track the market through it or you want to invest in the market riding on it? In my next post, I will deliberate further on how we can best segregate the indexes based on the criteria cited above.
