Understanding Indexing...

Some of our readers may be surprised to find out that indices determine (for the most part) the performance of most assets under management. Yes – it is the index, not the manager skill that dominates the performance of most large institutional portfolios worth hundreds of millions of dollars.

You see, when institutional investors allocate money (in the traditional world), they don’t give the manager a free hand to do whatever they see fit. Instead, most of the time institutional investors select an index (like the S&P 500 or the Bloomberg Barclays Global Agg) that the investment manager is tasked to outperform. So, if the index’ performance (i.e., the benchmark) over a certain period was -10%, but the manager delivered -9%, then the manager did a great job and certainly earned their management fee. And because benchmarked portfolios typically have restrictions on the amount of risk that the manager can take, the volatility that arises from active risk-taking (also known as Tracking Error) is typically materially lower than the volatility of the underlying asset class.

Put more simply, most of the portfolio’s performance is indeed driven by the returns generated by the index acting as a benchmark.

It is for this reason alone that developing a clear understanding of how indices are constructed is a crucial task that every serious investor needs to tackle. Let’s take the S&P 500 as an example. Most people would assume that because it includes the 500 largest companies in the U.S., the index is an unbiased representation of the whole U.S. economy.

Well, this is not exactly true.

Because the S&P 500 is a market-weighted index, it is highly skewed towards a few companies with extremely large market capitalization. To illustrate, consider the top 5 companies in the S&P500 – Apple, Microsoft, Amazon, Alphabet, and Tesla – whose total market capitalization is just below 21%. That is 1% of all the companies in the S&P 500 make up more than 1/5 of the whole index. In essence, what a portfolio benchmarked against the S&P 500 gets is overexposure to the tech sector and (much less than commonly believed) exposure to the broader U.S. economy.

In the Trend Following world, there are also popular indices that are broadly used by investors. On one hand, these indices are considered a gauge of how well the Trend Following industry is doing as a whole, on the other investors may use them as a benchmark to compare the performance of their manager. Hence even in the Trend Following domain, it remains important to understand how indices such as the SocGen Trend Index or the BTOP50 Index are constructed and rebalanced.

Failing to do so, may give you a false representation of the Trend Following industry or may lead you to false conclusions about the performance of your own Trend Following portfolio/manager.

Thankfully, Richard Brennan was a guest in this week’s episode of the Systematic Investor podcast series and elaborated extensively on this very topic. In his highly analytical style, Richard cast light on some of the peculiarities and weaknesses of the popular trend following indices.

And, as usual, Richard also offered an alternative to these indices, which we at Top Traders Unplugged truly believe are superior in a wide array of aspects. Yes, we are talking about our own TopTradersUnplugged Trend Following (TTU TF) Index.

Curious to find out more about this? Feel free to tune into this week’s episode of our Systematic Investor podcast series and find out yourself. As usual, we promise your time will be well spent.