Investment Oxymora

by: Brad Zigler

This article originally appeared in the March/April issue of the Journal of Indexes.


The word oxymoron is derived from the Greek roots for sharp and dull. It's fitting for the word to be, in itself, an oxymoron, don't you think? The investment lexicon is chock-full of oxymora. One of my favorites is a creation of those jovial guys and gals at the Internal Revenue Service. ''Passive activity'' ought to describe my half-hearted attempts at weekend gardening, but no: To the IRS it means ''an activity in which you do not materially participate.'' Wait a minute. That DOES describe my gardening efforts.

No matter. Real estate rentals and limited partnerships are examples of passive activity. One could argue that the passive activity tag could also be applied to enhanced index funds. Remember enhanced index funds? Back in the old days-what, about five or six years ago?-enhancement meant adding a little ''activity'' around the edges of a ''passive'' portfolio. Maybe you'd buy index futures and squeeze a little alpha out of the fixed-income collateral. Or perhaps you'd sell calls on your benchmark portfolio. But nowadays ... well, nowadays it's different. A LOT different. There has been a slew of new ''indexes'' launched recently to support exchange-traded funds that seem to stretch at the fabric of passivity mightily. Enhancement isn't needed anymore, thankyewverymuch. We can just launch indexes at will now.

PowerShares fired the first shot of the ''intelligent indexing'' revolution in 2002 and it's been ''Katie, bar the door'' since then. Oddly, the proprietary Intellidex methodology seems almost transparent when compared with some of the black boxes driving the newer creations.

As more and more complex methodologies are introduced, it seems the index world is being split asunder. And that's precisely the point Richard Ferri makes in his latest tome, The ETF Book: All You Need To Know About Exchange-Traded Funds. ''Market indexes,'' says Ferri, ''are measurement tools designed to reflect performance of financial markets and segments of those markets.'' These are the conventional benchmarks used by economists, central banks and the general financial industry in which securities are passively selected and capitalization-weighted.

Ferri reserves the term ''strategy indexes'' for those products whose only raison d'être is to be licensed as commercial investment products or to promote other products. ''They're not market yardsticks, nor are they used in academics or economics or in any asset allocation model. Strategy indexes are created using an alternative security selection method or an alternative weighting method, or both,'' says Ferri.

By Ferri's view, then, if an index isn't comprised of passively selected securities or isn't capitalization-weighted, it's really a strategy.

Ferri disdains the newfangled things, saying ''there is no conclusive evidence'' that the strategies provide investors actual financial benefit. ''The hypothetical index return data highlighted in product marketing material is all backtested to perfection,'' he gripes.

''Only time will tell if there are financial benefits in reality after fees and expenses.'' Ferri's book offers investors a way to sort out the fractious index fund market through a takeoff on the Morningstar style boxes. The vertical axis of Ferri's grid/box defines security selection methods, from bottom to top, as ''passive,'' ''screened'' and ''quantitative.'' Along the horizontal axis, from left to right, are the security-weighting schemes including ''capitalization,'' ''fundamental'' and ''fixed weight.''

A word to index providers: If you want to get on Ferri's good side, your product should occupy the lower left corner of his grid. For financial advisors of this sort, there seems little to be gained by thinking outside this box.