Index Investing

by: Roger Nusbaum

This post is going to frame out a thought I've made before but with a little more specificity. The title of the post, "Index Investing," indicates something different from being a mostly passive indexer. Someone who is a mostly passive indexer does not believe value can be added with stock selection, country selection or sector selection. Note that I am saying "mostly passive" with the idea that mostly passive will rebalance. At the Inside ETF Conference, a lot of people seemed to think that truly passive wouldn't even rebalance.

So the above would be more along the lines of an indexer as most people think of the term. Index Investing, as I am trying to frame it, is using indexed products to build an active strategy with exposures of varying narrowness (depending on comfort levels with very specific themes).

One of the advantages of ETFs over traditional mutual funds (and I guess we should now say actively-managed ETFs) is that in terms of looking forward (I think of portfolio construction as combining knowledge of market history with what appears to be going on now to make a forward-looking analysis), you know what a given ETF will look like six months from now. For better or worse, the EG Shares China Infrastructure ETF (NYSEARCA:CHXX) will always be heavy in real estate stocks. At times this will be a positive, and at other times a negative, but the exposure will be there -- well, unless all the stocks in the segment go to zero.

From the conference last week (again), there was an underscoring that professionals are reticent to pick individual stocks (I think at least a few individual names is very important, but that is a different story) but see the need to go narrower than SPY and EFA. Assuming there is a preference for not outsourcing completely to a collection of actively-managed funds and without single stocks, then narrower indexes become an answer.

The Market Vectors Rare Earth/Strategic Metals (NYSEARCA:REMX) will always be about volatile materials exposure; the general attributes and exposures in a fund are going to be the same in the future as they are today. Building a portfolio requires analysis and ongoing work. The consequence for being wrong about the analysis and ongoing work for a single stock is obviously worse than being wrong about that stock when it is a component of an index.

As a microcosm, yesterday BHP Billiton (NYSE:BHP) was down 1.33%, perhaps as fallout from the earnings report. BHP is the largest holding in both the iShares Global Materials ETF (NYSEARCA:MXI) and the iShares Australia ETF (NYSEARCA:EWA), yet those funds were up 0.62% and 0.97%, respectively. If you own either fund (both are in our ownership universe), you need to have an inkling of what is going on at BHP and want the exposure. Sticking with the example, BHP might be a great hold but the consequence for the exposure was obviously muted yesterday as the ETFs each had a pretty good day.

If the idea in this post seems obvious, then you are somewhat ahead of a lot people. Occasionally it is worthwhile to go over what might be obvious for some -- because I know it is not obvious for everyone.