Indices were originally invented to serve as a benchmark, or reference point, for measuring the ability of managers. The index is essentially a sample of the opportunity set of all securities available within an asset class. Therefore, a comparison of the returns of a manager with those of an index is entirely reasonable. Yet, what happens when the index becomes a business? That is to say, what happens when the reference point itself is marketed as an actual portfolio that competes with the managers being measured by that reference point? Is it still legitimate to use the index as a reference point if it’s also being used as a business?

To explore those questions, let’s consider the scientific method employed to conduct objective inquiry in the western world. One can divide the scientific method simplistically into two spheres: observation and experimentation. In observation, a classic example might be ancient astronomers observing the stars. The act of observing the stars in no way alters the reality; however, even in such a simple observation there can exist that which a statistician would call confounding variables. For instance, no modern astronomer would dare draw any conclusions from viewing the night sky in a large city, because of the distortions created by ambient light. In that case, ambient light is a confounding variable.

In experimentation, it’s easy to see how a confounding variable might exist. For instance, if half a group of patients afflicted with a given disease are given a drug while the other half are given a placebo, some of the possible confounding variables would include differences in age, health, quality of medical care and so on. Any of those variables might possibly explain results achieved in the experiment. In fact, to achieve experimental results without the existence of confounding variables is one of the great problems of science.

In the case of indexation, the largest holders of virtually any company in the S&P 500 (INDEXSP:.INX) include BlackRock, Inc. (NYSE:BLK), State Street Corporation (NYSE:STT), Vanguard, TIAA-CREF, and Invesco PowerShares, which are all well-known indexation firms. There are over $1 trillion worth of assets in ETFs which, after all, are merely indexes. The total amount of money invested in the many and various passive strategies, whether in separate account form or in structured product form, is clearly many times larger than that existing in ETFs. No one knows with any degree of precision how much money is actually indexed. Moreover, no one is in a position to know, since no small portion of indexation money is invested via derivatives, and no hard figures are readily available. Given that situation, one may ask if anything is proven by the fact that the passive strategies have outperformed the active strategies, except that investors have been convinced to purchase trillions of dollars’ worth of passive strategies.

If the issues at stake were merely those of measuring relative performance, this would be a trivial subject; however, the issue is much more profound. For example, the central concept of indexation is to hold the index portfolio for long periods of time since, in principle, there is no statistical advantage in attempting to time the ebb and flow of the market. Nevertheless, in the 11 months of 2011 through November, roughly $1 trillion worth of ETFs produced a trading volume with notional value of $18.9 trillion.

This year-to-date amount means that there’s little basis to doubt that notional trading volume will comfortably exceed $20 trillion by the end of 2011. Consequently, using the $1 trillion of indexation strategies represented by ETFs as a proxy, these indexes turned over 20 times, or 2,000%. The U.S. equity long category had $476 billion of ETF assets at the end of November 2011. Its notional trading volume on a year-to-date basis through November 2011 was roughly $12.3 trillion.1 The U.S. indices’ turnover was therefore 25.8 times, or 2,580%.

Via Horizon Kinetics