More than 4,400 ETFs are currently available globally, and more than one million indices are calculated daily—“a dizzying range of asset classes, strategies and exposures.” In Beyond Smart Beta: Index Investment Strategies for Active Portfolio Management (Wiley, 2017) authors Gökhan Kula, Martin Raab, and Sebastian Stahn explore exchange-traded products and the evolution of indexing to “unchain innovation—the future of active investing in passive products.”
After a lengthy account of the characteristics of exchange-traded products, the authors turn to the evolution of indexing. The first generation of indexing ties classic benchmark indices to “the market”—the Dow Jones Industrial Average, to cite the most classic. The authors provide 24 mostly full-page tables highlighting the main features of major benchmarks—equity, sector, fixed-income, and commodities.
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Smart beta indices represent the second generation. They are “designed to provide exposure to specific factors, market segments or systematic strategies.” Typical factors are value, size, momentum, low volatility, quality, and dividend yield. The authors analyze each of these factors, pointing out their advantages and disadvantages.
In the third generation of indexing, optimized indexing is combined with risk-based dynamic asset allocation. This generation of indexing aims “to control for and to mitigate costly behavioral biases.” One example is target volatility indexing. “Investors in equity-based ETFs are always better off in the long run investing in the corresponding target volatility ETF instead of the pure equity ETF.” Another example is the best-of-assets strategy, which switches allocation levels between equities and fixed-income depending on specific market signals.
One trend that has legs is customized indexing, where investors can construct a bespoke index solution that may exhibit a better risk-return profile for their specific needs. MSCI is currently calculating more than 7,000 customized indexes globally for over 700 clients, around 70% of which can be launched within 48 hours.
Academics keep churning out papers, firms keep churning out new ETFs. There’s no end in sight.