Beyond Smart Beta E-Book

Gökhan Kula

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 371

Veröffentlichungsjahr: 2017

Beschreibung

Delve into ETFs for smarter investing and a weatherproof portfolio Beyond Smart Beta is the investor's complete guide to index investing, with deep analysis, expert clarification and smart strategies for active portfolio management. From the general to the obscure, this book digs into every aspect of Exchange Traded Funds (ETFs) including ETCs and ETNs to break down the jargon and provide accessible guidance on utilising the indices as part of a more productive investment strategy. Succinct explanations of terms and concepts help you better grasp ETP anatomy, mechanics and practices, while examples, charts and graphs provide quick visual reference for total understanding. The expert author team examines the risks and benefits associated with various indexing approaches, sharing critical review of next-generation methods to help you make well-informed investment decisions. ETFs provide a solid foundation within mature and well-researched markets, allowing investors to focus on areas where active management has the potential to reap higher returns. This book shows you how to take full advantage of the growth of this market to strengthen your portfolio for the long term. * Assess the current landscape and the anatomy of ETFs/ETPs * Understand ETP handling, costs, trading, and investment * Evaluate the pros and cons of next-generation indexing approaches * Avoid risk while incorporating indices into an active portfolio management strategy Index concepts have evolved from basic, passive investments through Smart Beta, and are evolving into a third generation of products that will quickly become an important element of investor portfolios. Key benefits have propelled ETFs to surpass hedge funds in global capital, and the growth shows no sign of slowing. Beyond Smart Beta provides a primer for investors seeking to understand -- and take advantage of -- these lucrative new products.

Leseprobe

Table of Contents

Cover

Title Page

Copyright

Preface

Note

Acknowledgments

About the Authors

Chapter 1: The Beauty of Simplicity – The Rise of Passive Investments

Outperformance – A Tough Challenge

Institutional Investors: A Small Change in Allocations, A Big Step for Passive Investments

Not All “Big Guys” Love Etfs

Note

Chapter 2: The History of Indexing and Exchange‐Traded Products

Frequent Pricing Thanks to Copper And Feather

Journalist Trio Pictures the Market

Indexation Across the Globe

Customized Indexing aka Smart Beta

Exchange‐Traded Funds – A Unique All‐rounder

Exchange‐Traded Commodities – Heavy Metal Even for Lightweight Investors

Exchange‐Traded Notes – The Underdog

Notes

Chapter 3: Index Evolution

Benchmark Indices

Smart Beta Indices (Second Generation of Indexing)

Next Generation Indices (Third Generation Of Indexing)

Notes

Chapter 4: The Good, Bad and Ugly – A Critical Review of Today's Indexing Approaches

Synthetic vs. Physical Replication

Second Generation Indexing Critique – The Bad Ones

Commodity/Energy/Oil ETP Products

Volatility ETPs

Notes

Chapter 5: Advantages Unlimited – Portfolio Application Strategies for Superior Index Investing

Never Underestimate the Importance of Investment Costs

Smart Beta Deconstruction

Conclusion

Mind the Behavioral Gap – Earning More by Avoiding Investing Errors

The Next Generation of Asset Allocation – Risk Factor Allocation Approach in Portfolio Construction

The Ultimate Question: Passive or Active?

Notes

Chapter 6: Unchaining Innovation – The Future of Active Investing in Passive Products

Alternative Investing

Environmental, Social and Governance (ESG)‐Based Investments

Conclusion

Customized Indexing

Notes

Glossary

References

Index

End User License Agreement

List of Tables

Chapter 2

Table 2.1 Key milestones in the still‐young history of exchange‐traded funds and index investing.

Table 2.2 Global ETP Providers Ranked by Assets (US$bn)

Table 2.3 Europe ETP Providers Ranked by Assets (US$bn)

Table 2.4 Asia‐Pacific ETP Providers Ranked by Assets (US$bn)

Table 2.5 Market Close on Day 1

Table 2.6 Market Close on Day 2

Chapter 3

Table 3.1 Dow Jones Industrial Average Index

Table 3.2 Standard & Poor's 500® Index

Table 3.3 Nasdaq 100® Index

Table 3.4 Russell 3000® Index

Table 3.5 Bovespa® Index

Table 3.6 EURO STOXX 50® Index

Table 3.7 FTSE 100® Index

Table 3.8 DAX 30® Index

Table 3.9 MDAX® Index

Table 3.10 Hang Seng® Index

Table 3.11 Nikkei 225® Index

Table 3.12 MSCI World® Index

Table 3.13 MSCI Emerging Markets® Index

Table 3.14 Dow Jones Sector Titans™ Indices

Table 3.15 S&P Select Sector Indices

Table 3.16 STOXX Europe 600 Sector Indices

Table 3.17 Bloomberg Barclays Global Aggregate Index

Table 3.18 World Government Bond Index

Table 3.19 J.P. Morgan Emerging Market Bond Index

Table 3.20 markit iBoxx Indices

Table 3.21 BofA Merrill Lynch Indices

Table 3.22 S&P Goldman Sachs Commodity Index

Table 3.23 Thomson Reuters Core Commodities CRB Index

Table 3.24 UBS Bloomberg CMCI® Total Return Index

Table 3.25 MSCI USA Index vs. MSCI USA Value Index

Table 3.26 MSCI USA Index vs. MSCI USA Small Cap Index

Table 3.27 MSCI USA Index vs. MSCI USA Momentum Index

Table 3.28 MSCI USA Index vs. MSCI USA Minimum Volatility Index

Table 3.29 MSCI USA Index vs. MSCI USA Quality Index

Table 3.30 MSCI USA Index vs. MSCI USA High Dividend Yield Index

Table 3.31 Overview of Factor Exposures

Table 3.32 Top Holdings Nasdaq 100

Table 3.33 Overview of Factor Indices

Table 3.34 Risk‐Return Analysis of Different Beta‐1 Strategies

Table 3.35 Dynamic Asset Allocation Strategies

Table 3.36 Risk‐Return Figures Best‐of‐Assets

Chapter 5

Table 5.1 Relevant Risk Factors

Chapter 6

Table 6.1 Alternative Exchange‐Traded Products at a Glance (listed on a U.S. Exchange)

Table 6.2 Descriptive Statistics for SRI and Non‐SRI exposures

Table 6.3 Risk Adjusted Performance for SRI Exposures

Table 6.4 Empirical Results From the 1‐factor (CAPM) Model

Table 6.5 Empirical Results From the 5‐factor Model

Table 6.6 R

2

from the Trend Regression Using Different Valuations

List of Illustrations

Chapter 1

Figure 1.1 Usage of Active vs. Passive Strategies – Pension Assets

Figure 1.2 Usage of Active vs. Passive Strategies – Non‐Profits

Figure 1.3 Proportion of Active vs. Passive – Pension Assets

Figure 1.4 Proportion of Active vs. Passive – Non‐Profits

Chapter 2

Figure 2.1 Global ETF Assets

Figure 2.2 Global ETP Providers Ranked by Assets

Figure 2.3 Europe ETP Providers Ranked by Assets (US$bn)

Figure 2.4 Asia‐Pacific ETP Providers Ranked by Assets (US$bn)

Figure 2.5 Counterparty Exposure of an ETF

Figure 2.6 The Creation and Redemption Process

Figure 2.7 Securities Lending Revenue Streams

Chapter 3

Figure 3.1 Industry Classification Benchmark

Figure 3.2 Global Industry Classification Standard

Figure 3.3 MSCI USA Index vs. MSCI USA Value Index

Figure 3.4 MSCI USA Index vs. MSCI USA Small Cap Index

Figure 3.5 MSCI USA Index vs. MSCI USA Momentum Index

Figure 3.6 MSCI USA Index vs. MSCI USA Minimum Volatility Index

Figure 3.7 MSCI USA Index vs. MSCI USA Quality Index

Figure 3.8 MSCI USA Index vs. MSCI USA High Dividend Yield Index

Figure 3.9 Smart Beta Correlations

Figure 3.10 Performance of Smart Beta Strategies

Figure 3.11 Longest Periods of Underperformance

Figure 3.12 Performance Dependent on Interest Rate Moves

Figure 3.13 Evolution of Indexing

Figure 3.14 Behavioral Return Gap

Figure 3.15 Maximum Drawdown Comparison

Figure 3.16 Return Paths of Different Factor Indices

Figure 3.17 Risk‐Return Characteristics of Different Factor Indices

Figure 3.18 Positioning of Market Cycle Engine

Figure 3.19 MYRA Dynamic Factor Strategy

Figure 3.20 Upside‐Downside Relationship of Returns

Figure 3.21 Target Volatility Strategy

Figure 3.22 Target Volatility Strategy – Realized Volatility

Figure 3.23 Asset Allocation Shifts Best‐of‐Assets

Figure 3.24 Maximum Drawdown Best‐of‐Assets

Figure 3.25 Performance Chart Best‐of‐Assets

Figure 3.26 Yearly Returns Best‐of‐Assets

Chapter 4

Figure 4.1 Performance Persistence of Smart Beta Indices

Figure 4.2 Futures Curve of WTI

Figure 4.3 WTI Performance vs. Investment Products

Figure 4.4 VIX Volatility Index

Figure 4.5 VIX Futures Term Structure

Figure 4.6 Performance of iPath S&P 500 VIX ST Futures ETN (VXX)

Chapter 5

Figure 5.1 Expense Ratios of Active vs. Passive Investments

Figure 5.2 The Power of Compounding

Figure 5.3 Returns Based on Expense Ratios

Figure 5.4 Smart Beta Flows

Figure 5.5 Cost, Timing and Selection Penalty

Figure 5.6 Categorization of Risk Factors

Figure 5.7 Average Cross‐Correlations

Figure 5.8 Risk Factors in Asset Allocation

Figure 5.9 Traditional vs. Factor Portfolio

Chapter 6

Figure 6.1 AuM vs. Spread of Alternative ETFs

Figure 6.2 Performance vs. Price‐to‐Book Valuation

Figure 6.3 Increase in Factors and Papers

Figure 6.4 Nasdaq 100 Index

Figure 6.5 Swiss Market Index

Guide

Cover

Table of Contents

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Beyond Smart Beta

Index Investment Strategies for Active Portfolio Management

GÖKHAN KULAMARTIN RAABSEBASTIAN STAHN

This edition first published 2017

© 2017 Gökhan Kula, Martin Raab and Sebastian Stahn

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Preface

Exchange‐traded funds (ETFs) and index‐linked investment products have enjoyed more than two decades of massive growth. They emerged from quirky no‐name products to become rock stars. Institutional investors along with retail investors use passive instruments more and more as important building bricks for their portfolios.

Thanks to their compelling benefits for all kinds of investors and the growing demand for liquid, cost‐effective exchange‐traded products (ETPs), global assets under management in ETFs/ETPs grew jointly to over US$3.408 trillion at the end of Q3 20161. Among financial professionals, ETFs are meanwhile very well known. But not all professionals have already realized that they should not only understand the product wrapper, which is the ETF, but also the index, which the ETF tracks effectively. Also, there are some developments in the indexing space which will enrich investors' possibilities.

As always, more choice leads potentially to greater confusion. Nowadays, more than 4,400 ETFs are available globally and this number is increasing every day. Even more explosive growth happened in the index sector itself. Meanwhile there are more than one million indices calculated daily – a dizzying range of asset classes, strategies and exposures.

With this book, we want to provide a clear picture about what ETFs/ETPs are able to offer the investor (and what not), how to use them for specific investment needs and advanced portfolio strategies. In addition, we have packed many practice examples into the index evolution chapter in order to shed some light on facts which are sometimes overlooked. Also, we put a strong emphasis on the latest developments in indexing and how investors could benefit most from blending active management with passive products.

Despite all the transparency initiatives, we witnessed that it could be hard for investors to research current data and details about various indices. Some index providers lack transparency. In some cases, investors could bypass the black boxes that index providers created artificially by directly looking into holdings and weightings of the ETF. Anyway, we collected the essential data in this publication – and saved you valuable time. Time you could use to consider active index investment strategies for your portfolio.

We wish you successful active decisions and long‐lasting outperformance while using index investments!

NOTE

1

. ETFGI as of October 19, 2016

Acknowledgments

This book is a synergistic product of three friends who have been active in the financial industry since the mid‐1990s, blessed with domain expertise and still enthusiastic about investments, portfolio management and financial products.

For the development and production of this book we want to express our gratitude to:

Gemma Valler

, our Commissioning Editor, and

Jeremy Chia

, Content Development Specialist, at John Wiley & Sons for their outstanding support and mentoring through all stages of this publication.

Thomas Merz

, Managing Director, UBS Global Asset Management, for his contribution about using ETFs for Environmental, Social and Governance (ESG) Based Investments.

David Lichtblau

, former Chief Executive Officer,

ETF.com

, for his permission to support this book with selected data.

Linda York

, Senior Vice President, Syndicated Research and Consulting at Market Strategies International, and

Anne Denz

, Director at Market Strategies International, for their survey data.

Markus Schuller

, Managing Partner Panthera Solutions, for the continued joint research cooperation and the always enriching input.

Dwijen Gandhi

, Managing Director, New York Stock Exchange, for the support concerning the NYSE Dynamic US Allocation Index.

Finally, this project was only possible with the patience and support of our wonderful families and wives: Ayse, Christina and Kathrin.

About the Authors

Gökhan Kula, Chartered Financial Analyst™, Financial Risk Manager™

Gökhan is Managing Partner and Chief Investment Officer of MYRA Capital, an investment management company specialized in systematic investment strategies and advanced indexing solutions. He is a proven capital markets expert with over fourteen years of experience in the European investment industry with relevant track record and awards. Following various management positions in the asset management of the Walser Privatbank AG, he was appointed as the Managing Director of the Walser Privatbank Invest S.A., which was established in January 2011. In addition, he was board member to several Luxembourg investment companies. He has gained his MA at the University of Innsbruck and University of Bradford. He is a regular interviewee in various financial media from Germany, Austria and Switzerland.

Martin Raab, Chartered Alternative Investment Analyst™

Martin has extensive experience in financial products, including derivatives and ETFs as well as cross‐asset portfolio management and holistic client advisory. Over the years, he became an internationally recognized investment expert and publisher (quoted in business publications including Politico, Bloomberg Brief, Handelsblatt and Finanz und Wirtschaft). He started his career in finance in 1996 with a bank apprenticeship. After positions in institutional asset management, Martin became part of a newly formed joint venture between a large U.S. bank and the world's largest bond manager, with offices in Munich, London and Newport Beach. His responsibility was for flagship funds, investing into structured bonds and complex derivatives. Afterwards, he continued his career working for five years with a German Landesbank as New Products/New Markets Executive. Since 2010, Martin has managed Switzerland's leading investor magazine as Executive Director. As regards his exchange‐traded funds and indexing capabilities, Martin has been appointed Senior Advisor to the Board of MYRA Capital AG, Salzburg/Frankfurt, mainly responsible for cross‐border index projects, together with the New York Stock Exchange. As Founding Partner of two U.S. financial companies, Martin has been actively involved in the transatlantic business for seven years. His profile is completed by a Bachelor in Business Administration (Faculty Degree, TU Munich) and a diploma as a Chartered Alternative Investment Analyst (CAIA).

Sebastian Stahn, Chartered Financial Analyst™

After his education as a banking specialist, Sebastian studied business administration at the University of Applied Sciences Landshut and Anglia Ruskin University Cambridge. He is a CFA charterholder and dedicated his education and research focus particularly to the areas of ETFs and indexing. After his studies he worked as a fund manager and advisor to institutional clients at Walser Privatbank and MYRA Capital, an investment management boutique with a strong focus on efficient and rules‐based investment strategies. In 2017 he joined Wüstenrot Group as Treasury & Investment Manager. Stahn specializes in absolute‐return and portfolio insurance concepts and is a renowned expert on efficient, forecast‐free and rules‐based investment strategies.

CHAPTER 1The Beauty of Simplicity – The Rise of Passive Investments

In the old days, asset management was a pretty straightforward business: A fund manager, skilled and equipped with the ability to find attractive deals and investments in the financial markets, took care of the investor's money and got in exchange a decent fee and tried to increase profit. The majority of fund providers or portfolio managers in the asset management industry tried to pick attractive stocks, bonds or other securities, to decide when to move into or out of markets or market sectors, and to place leveraged bets on the future direction of securities and markets with options, futures and other derivatives. Their objective over the year was to make a nice profit, and, sometimes by chance, to do better than they would have done if they simply accepted average market returns.

In pursuing their objectives, active managers searched out information they believed to be valuable, employed legions of research analysts in all parts of the world, and often developed complex or proprietary selection and trading systems. Active management encompasses hundreds of different methods, and includes fundamental analysis, technical analysis (interpreting charts) and macroeconomic analysis, and all of these have in common an attempt to determine profitable future investment trends. But don't be too impressed: if one looks behind the curtain, in some cases a “proprietary selection” is often nothing more than a simple play with Bloomberg's equity screening and its back‐testing tools or one of replicating the investment strategy of a competitor firm.

OUTPERFORMANCE – A TOUGH CHALLENGE

In the mid‐1970s, change came to the active asset management world. Not radical change, but the active world faced some competition for the first time from the pure, minimalistic approach of passive investing, namely the index fund. As described in detail in the next chapters, at this time the first generation of passive investments was born. An index fund provides investors with a return and performance equaling the underlying market. The market is effectively a well‐known benchmark index like the S&P 500®, Euro STOXX 50®, FTSE100® or the DAX®. While the idea of consistent, market‐beating returns that transform a smaller initial investment into greater wealth was and is still attractive to millions of investors, the reality over the last decade shows clear evidence that outperforming broad markets over longer periods of time has become more and more challenging. A matrix of the best‐performing asset classes in each year or the hot stocks of one year will often become poor performers in the following year.

As a result, settling for achieving, rather than exceeding, market return is an increasingly popular option. Rather than trying to guess which investments will outperform in the future, index fund managers try simply to replicate the gains in a particular market, sector or, nowadays, factor. This means that they invest in all or most of the securities in the index – a technique called “indexing”. Also, increasingly volatile markets, shifting correlations and the most recent disruptive interventions of many central banks have made it even more challenging for active managers to correctly predict the winning stocks or assets and to outperform the market or a sector. Therefore, many investors who are looking for exposure to broad markets and low costs switch to passive investment products.

INSTITUTIONAL INVESTORS: A SMALL CHANGE IN ALLOCATIONS, A BIG STEP FOR PASSIVE INVESTMENTS

Despite the massive rise of passive investments, active managers will probably not become the dinosaurs of the financial industry as smart investment ideas always stay in fashion. Particularly in some exotic investment spaces like Frontier Markets, Small Caps or Alternative Investments, skilled active managers have good chances to generate extraordinary returns. However, the broader the market, the more rapidly the chances of delivering returns that outpace market returns are diminishing. Also, buy‐side investors are more and more sensitive with regard to costs and outperformance over time. Thrifty retail investors, with no sizeable amount of assets that would justify hiring a smart investment advisor, stick more and more to passive products like ETFs for their core investments. Sophisticated institutional clients like pension trusts, endowments and other “big dollar investors” are increasingly reviewing their investment mandates to decide whether their external managers effectively run a truly active managed portfolio – and therefore are justified to charge higher management fees compared with a passive mandate – or merely replicate an ordinary index.

Although the majority of fund assets are still actively managed, there has been some decrease in allocation to active funds over the past three or four years, according to the ETF sell‐side. Mostly after the financial turmoil in 2008, the institutional world became more receptive to passive investments – though they did not switch every single one of their assets into ETFs. Of course, that is a story that the ETF industry often tends to tell a bit differently. According to the latest issue of the US Institutional Investor Brandscape® report, one of the most detailed surveys of institutional ETF usage, published by Cogent Research in spring 2016, the vast majority of pension investors, over 95%, still incorporate actively managed strategies in their institutional portfolios. There is a similar picture in Europe. In the 2016 edition of Mercer's European Asset Allocation Survey, which reflects data and feedback from nearly 1,100 institutional investors across 14 countries representing assets of around €930 billion, only 3% of participants in the survey reported any direct exposure to ETFs. This means that €28 billion from these institutional market participants is invested in ETFs already.

NOT ALL “BIG GUYS” LOVE ETFS

A detailed picture of the current state of active vs. passive investment styles can be painted based on the US Institutional Investor Brandscape®1: Figures 1.1 to 1.4, which show the results of the 405 investors managing $20 million or more in institutional investable assets, show that the use of active management varies little by asset size, ranging from 93% among pensions managing between $250 million and $1 billion in assets to 100% of the $1 billion‐plus pensions. Interestingly, when questioned about their current usage of passively managed strategies, only 68% of the pension plans in 2016 report that they are using them, down from 81% in 2014. Notably, the use of passive investments is lowest among the cohort of smallest pensions, as just 54% of pensions managing less than $100 million in assets invest in passive instruments. Conversely, pension plans managing larger assets are much more likely to allocate at least a portion of their assets into passive products or to devote some portion of their assets to passive strategies (90% of pensions managing between $250 million and $1 billion in assets and 82% of $1 billion‐plus pensions). Corporate pensions appear to be driving the decrease in use of passive investments. Some experts assume this might be a reflection of the reliance on liability‐driven investment strategies among this cohort of the pension market.

FIGURE 1.1Usage of Active vs. Passive Strategies – Pension Assets

Source: Market Strategies International, “The Pull of Active Management – Examining the Use of Active vs. Passive Strategies in the Institutional Marketplace”, April 2016

FIGURE 1.2 Usage of Active vs. Passive Strategies – Non‐Profits

Source: Market Strategies International, “The Pull of Active Management – Examining the Use of Active vs. Passive Strategies in the Institutional Marketplace”, April 2016

FIGURE 1.3 Proportion of Active vs. Passive – Pension Assets

Source: Market Strategies International, “The Pull of Active Management – Examining the Use of Active vs. Passive Strategies in the Institutional Marketplace”, April 2016

FIGURE 1.4 Proportion of Active vs. Passive – Non‐Profits

Source: Market Strategies International, “The Pull of Active Management – Examining the Use of Active vs. Passive Strategies in the Institutional Marketplace”, April 2016

In the non‐profit world, where 89% of organizations utilize actively managed strategies, the picture seems similar as regards a decreased usage of passive strategies, and this decrease appears to be driven by the smaller institutions which manage less than $250 million in assets. However, there is a growing fan base among the non‐profits: foundations report an increase in their use of passive strategies compared with 2013, and are the only segment of the non‐profit market to have boosted their use of passive management over the past three years. The use of other asset classes is more prevalent among non‐profits (88%) than among pensions (78%) and is noticeably higher among the $1 billion‐plus segment. In addition, 95% of foundations incorporate these asset classes in their portfolios – that is higher than any other type of institution.

One aspect that has not changed is what drives asset allocation changes. Institutional investors continue to follow two divergent paths: the focus of pensions is very clearly on de‐risking, while non‐profits seek higher returns and further diversification. Thus asset managers serving the institutional market need to employ dramatically different strategies, with distinct product offerings to retain and cultivate existing relationships and position themselves effectively for consideration for future mandates.

NOTE

1

. Market Strategies International, 2016

CHAPTER 2The History of Indexing and Exchange‐Traded Products

In today's world, there are a lot of indices – some of them are directly investable and some not. Often cited in the media and closely monitored by investors are consumer price indices, indices reflecting home prices and indices reflecting asset prices of stocks, bonds or commodities. However, indexing is nothing new really. Frequent price quotations of certain goods or values have been recorded since the 18th century. Whether it was the price of tea from shiploads in the Boston harbor or wheat quotations of the historic Hanse merchants in Hamburg, traders and wholesalers have been always interested in price patterns. Particularly in the commodities sector, seasonal effects are still an important factor which drives prices up and down.

FREQUENT PRICING THANKS TO COPPER AND FEATHER

Price recordings of certain goods become more valuable as the speed of getting a fresh, updated price increases. In this way, the trader is able to react more quickly and can try to anticipate future price changes. Paul Julius Reuter recognized this when he arrived in the year 1851 in the British empire's capital from Aachen in Germany, where he had been running a news and financial media company using a combination of the then high‐end IT equipment called telegraph cables and a fleet of carrier pigeons. This smart combination of copper and feather helped Reuter to establish an enviable reputation for speed, accuracy and impartiality. Reuter's office at 1 Royal Exchange Building in London's financial district quickly became the place where continuous price quotations of stocks were available. Technically, he utilized the then new Dover‐Calais submarine telegraph cable for this newly invented “data stream”.

JOURNALIST TRIO PICTURES THE MARKET

With the continuous evolution of capital markets in Europe and the emerging United States, in the late 1800s a financial journalist named Charles Dow co‐founded a company called Dow Jones & Company with his two press mates Edward Jones and Charles Bergstresser. The trio published the Wall Street Journal and worked in New York City's financial district out of a basement office. Wall Street of 1882 was a vibrant place, crammed with established high‐society investors, distinguished bankers with top hats, ambitious immigrants from all over the world, wannabe‐rich‐fast brokers and bribed stock reports (perhaps some Wall Street critics would argue that parts of this “cocktail of interests” survived the last 130 years). Dow was the one who found a good solution for calculating the daily price moves of 12 large Wall Street stocks – mostly railways and heavy industrials then – on a frequent basis and simultaneously including corporate actions such as dividends and splits. The Dow Jones Industrial Average™ Index has become the oldest existing stock market barometer in the world. The index was increased to 20 constituents in 1916 and finally to 30 stocks in 1928. This index became the picture of the ups and downs in the American stock market. Despite all the respectable pioneer work that has given the Dow its reputation, this index has some flaws that investors should be aware of.

INDEXATION ACROSS THE GLOBE

With the computerization of the financial industry in the 1970s and 80s, more and more indices were launched. Surprisingly, the first notable index launch happened in Far East. On November 24, 1969 the Hang Seng Index was calculated the very first time by its Hong Kong‐based sponsor, the Hang Seng Bank. It is Hong Kong's globally recognized equity index. Two years later, on America's east coast, the Nasdaq Composite Index® was launched. Since February 5, 1971, with a starting value of 100, this index has represented all domestic and international common stocks listed on the Nasdaq Stock Market. Much older is the S&P 500 Index, which was initially introduced in 1923. The S&P 500 index in its present form started originally on March 4, 1957. This index is the most commonly used benchmark for stocks. In 1984, the Russell 2000 Index® was created and back‐tested until 1978. In the same year, the British equity barometer FTSE 100 index was launched. On January 3, 1984 the index was calculated with a starting value of 1,000 points (and back‐tested until 1969). A latecomer was the meanwhile well‐known DAX® index. The major index representing German large‐cap equities including companies like BMW, Daimler or Siemens was a joint project of the German regional exchanges, the Frankfurt exchange and the financial newspaper Börsen‐Zeitung. The DAX® index continued a precursor index calculated by Börsen‐Zeitung since 1959 that measured the performance of the German equity market. The DAX® was officially launched on July 1, 1988 with 1,000 points. One of the latest launches of a broadly recognized equity index happened in 1998. On February 26, the EURO STOXX 50® Index was introduced by index provider STOXX. The start level was 1,000 points – like most European index peers. This index quickly became the widely used reference for performance of Pan‐European (Eurozone) stocks.

CUSTOMIZED INDEXING AKA SMART BETA

With the rise of passive investment products like ETFs, index providers have been pushed into a battle over technology, speed and smart methodologies used to create new, advanced indices. Also, the indexing business began more and more to acquire a certain tailored flair. Hence five or six years ago, so‐called “customized indices” became more and more popular. Unlike predefined benchmarks, which have been created more or less solely by major index providers together with a couple of large banks or exchange providers to represent a general market gauge for the public, customized indices are designed based on the highly individual needs of certain investors. These tailored indices are available across a variety of asset classes, including but not limited to equities, fixed‐income, commodities, alternative strategies and even combinations of asset classes – so‐called “multi‐asset indices”. In this context, the financial industry created the well‐known and often‐cited names “smart beta”, “strategic beta” or “alternative beta” – but not each customized index is a smart beta strategy. This topic will be introduced in a couple of pages.

The rise of customized indices is also associated with declining costs for launching one's “own index”. For example, in 2005 a customized index was affordable for institutional investors only. A small asset manager was not in a position to create an index based on its own proprietary allocation model, because of the costs for such a venture. On average a high five‐figure amount was necessary to start a “build‐your‐own‐index” project. In the interim, custom indices have become a kind of standard offering – for almost each index provider globally. And more new players are entering the market. The new wave for tailored, unconventional (and often sold as smart beta) indices also influenced the acquisition strategies of various established exchanges. For example, in 2015, Deutsche Börse paid nearly $700 million for the takeover of index provider STOXX and its accompanying IT and indexing platform. A year earlier, London Stock Exchange Group paid $2.7 billion for Russell Investments, an index provider and asset manager, which was put up for sale by its parent company Northwestern Mutual. In 2016, LSE Group sold the asset management business of Russell Investments to TA Associates and Reverence Capital Partners for $1.15 billion and kept the indices business, which became FTSE Russell. But there are also a number of smaller emerging index providers (like the Frankfurt‐based Solactive or ERI Scientific Beta, with their customized index factory based on specific optimized index strategies), more or less fully focused on customized indices, which are enjoying increasing business activity. The driver for their soaring business is often an aggressive pricing model compared to large index providers. However, the journey is far from over. The latest trend in indexing leads to a blending of active and passive investment strategies, with the incorporation of existing capital markets models and advanced academic research. Before we shed light on the world of exchange‐traded products and then on advanced index strategies in portfolio management, we have first compiled a comprehensive summary of the most notable and relevant milestones in the history of index investing (Table 2.1).

TABLE 2.1 Key milestones in the still‐young history of exchange‐traded funds and index investing.

1969–1973

Experimental index labs:

The U.S. bank Wells Fargo, before it took over rival Wachovia, utilized various academic models to develop index investing. This project was led by John McQuown. Accordingly, Wells Fargo became a pioneer of index investing, launching the first index fund in 1971 with a $6 million investment from Samsonite Luggage Corporation's pension fund. This mandate should reflect the performance of 1,500 NYSE‐listed stocks. From an operational point of view, it turned out to be very difficult to manage. In particular, the portfolio's equal‐weight approach turned out to be “mission impossible” because of heavy trading costs in an era where US$5 flat‐fee commissions were unknown. Also, Wells Fargo developed the Stagecoach Fund, a portfolio of low‐beta stocks leveraged up so the beta of the portfolio was 1.0. The fund was set up as a closed‐end mutual fund to be marketed to pension funds and other institutions. After almost two years of marketing, only $30 million had been committed, so the fund was dropped in November 1973

1

. About the same time, the American National Bank of Chicago got convinced by its then employee Rex Sinquefield to create a trust based on the US S&P 500 Index, minimum investment US$100,000. The fund was only available to institutions, and the New York Telephone Company became its first major investor. Also, no‐load funds were introduced, a new way to attract investors for mutual funds while slashing fee layers.

1973–74

Index investing “manifesto” published:

The well‐known book

A Random Walk Down Wall Street

is published by Princeton University professor Burton Malkiel. He calls for the establishment of a low‐cost fund that reflected the market index, a laughable idea to most coevals in the fund industry.

1974–76

Vanguard launches first index mutual fund:

One year after its foundation, The Vanguard Group – under the leadership of the well‐known John C. Bogle – launched the first index fund for retail investors, the Vanguard® 500 Index Fund. It started with US$11 million assets under management. Today, this is the world's largest managed fund of any type, with assets of about US$250 billion

2

.

1990

World premiere of today's ETFs:

The world's first exchange‐traded, index‐linked fund was launched on the Toronto Stock Exchange (TSX). This product was labeled as the Toronto 35 Index® Participation Units. Eventually, this product structure became the precursor of today's ETF. In the same year, Vanguard created the first international share index funds available for U.S. investors.

1992

The factor model:

Eugene F. Fama and Kenneth R. French, both University of Chicago professors, published their legendary article “Common Risk Factors in Returns on Stocks and Bonds”. Fama and French's model compares a portfolio to three distinct risks found in the equity market to assist in decomposing returns. Prior to their findings, the Capital Asset Pricing Model (CAPM) was predominantly used as a “single factor” way to explain portfolio returns. Their findings are important for the evolution of indexing. Both gentlemen in 2013 received the Nobel Prize in Economic Sciences.

1993

The birth of America's first ETF:

Three years after the launch of an ETF in Canada, the American Stock Exchange (AMEX) together with State Street Global Advisors (SSgA) launched the first authorized stand‐alone index‐based exchange‐traded fund in U.S. history: the S&P Depository Receipts Trust Series 1, better known for its nickname “SPDRs”. The SPDR ETF is benchmarked to the S&P 500® Index. It quickly gained acceptance in the marketplace and became one of the most successful ETFs in the U.S.

1996

ETFs go international:

In March 1996, U.S. investment bank Morgan Stanley launched the first ETF containing non‐U.S. securities under the name WEBS, an acronym for “World Equity Benchmark Shares”. WEBS were 17 separate series of single‐country‐index‐based ETFs listed on the AMEX. It was later renamed by Barclays Global Investors as iShares MSCI (Morgan Stanley Capital International indices) series. This product introduced another important structural variation; it had an asset manager (as these ETFs were mutual funds), not a trustee. Barclays Global Investors (BGI) was the WEBS's manager.

1999

New sector‐tracking approach – without an index:

Merrill Lynch's Holding Company Depositary Receipts or HOLDRS introduced a new concept in tracking: portfolios of securities designed to cover various market sectors. These do not track an index. Instead, the stocks are selected at the time the HOLDRS is established, based on particular selection criteria such as company size and liquidity. A HOLDR is a fixed selection of stocks with a very specific selection. This selection does not change, and HOLDRs are not managed. As a result, they do not have the dynamic sector‐tracking aspect of an ETF. Stock selection represents a particular and narrow view of an industry or sector. If a company included in a HOLDR is acquired, or if it goes off the market, its shares are not replaced. HOLDRs are seen by those who favor them as offering a more specific type of market approach than ETFs. For example, with a HOLDR, an investor can follow a theme like “broadband” or “Internet security”. The AMEX has developed indexes based on types of HOLDRs.

Repack it – debut of Hong Kong's first ETF:

After the motto “virtue out of necessity”, the Hong Kong SAR Government was initiator of Hong Kong's first ETF. The Government acquired a substantial amount of Hong Kong‐listed stocks to sustain the exchange rate during the Asian Financial Crisis two years earlier. To prevent disruption to the domestic stock market, the Government decided to repack the equities portfolio into an exchange‐traded fund, called the Tracker Fund of Hong Kong.

2000

ETFs arrived in Europe:

In April 2000, Frankfurt‐based Deutsche Börse launched the so‐called “XTF” segment, where two exchange‐traded funds got listed: a EURO STOXX 50® ETF and a STOXX® Europe 50 ETF. The issuer for both was Merrill Lynch International with the LDRS product suite. The trading segment Xetra was Europe's first trading venue for ETFs and has since been one of the market leaders. Also in April, exactly 17 days after its then rivals in Frankfurt, the London Stock Exchange celebrated the listing of the UK's very first ETF, tracking the FTSE 100 index. In September 2000, ETFs hit the Alps: SIX Swiss Exchange introduced an ETF trading segment too. A few months later, German lender HypoVereinsbank (today Unicredit Bank) launched Indexchange, the first European ETF issuer.

First smart beta ETF was launched:

With its inception on May 22, 2000, the iShares Russell 1000 Value ETF (IWD) was the first smart beta ETF.

2001

Europe's first swap‐based ETF, made in France:

Lyxor, a fully‐owned subsidiary of French banking giant Société Générale, rolled out Europe's first swap‐based ETF in 2001. The performance of this synthetic‐replicated ETF was not generated by the underlying index portfolio but from a swap agreement with a counterparty. Swaps are nothing unusual or suspicious, but it was simply the first time that an ETF collateral basket (for example Japanese Government bonds) did not necessarily reflect the market or index an ETF is tracking (European Large‐Caps).

2002

ETF debut in Singapore:

Singapore's first ETF, the streetTRACKS Straits Times Index Fund, was listed on 17 April. ETF sponsor State Street Global Advisors attracted primarily a couple of large local institutional investors to subscribe for the product initially. Singapore retail investors spurned the “new thing” for a while because there was no leverage build‐in.

2003

World's first ETC launched down under:

In March 2003, Gold Bullion Securities – the world's first physically‐backed gold exchange‐traded commodity (ETC) – began trading on the Australian Stock Exchange. The ETC was developed by Gold Bullion Limited (a predecessor to the London‐headquartered investment product provider ETF Securities) in association with the World Gold Council over a nine‐month process.

3

2004

China's first ETF and the Gold ETF launched:

In January 2004, China Asset Management was approved to cooperate with the Shanghai Stock Exchange in developing the first ETF in mainland China

4

. After months of intense work, on December 30, 2004, the China 50 ETF was launched. A month before, in November 2004, State Street Global Advisors' streetTRACKS Gold Shares was listed on the New York Stock Exchange with the sponsorship and endorsement of the World Gold Council. After a name change in May 2008, the world's first physically‐backed Gold ETF trades as SPDR Gold Shares (Symbol GLD).

2005

World's first crude oil ETC:

In July 2005, ETF Securities listed ETFS Brent Oil, the world's first oil ETC.

2006

Premiere of Europe's physically‐backed gold ETF:

In March 2006, Zurich Cantonal Bank and Barclays Global Investors launched physically‐backed commodities ETFs: The Swiss‐based bank introduced its legendary Gold ETF (Symbol ZGLD) and Barclays launched the world's first silver‐backed ETF, iShares Silver Trust (Symbol SLV). The silver ETF raised great concerns over supply and demand among various commercial silver users.

2008