What the Indexes Don’t See

Not all benchmarks created equal

February 22, 2010

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Passive investing, in the form of investable indexes, is gaining more and more converts. Last month, it was reported that Norway’s Government Pension Fund was taken to task by the country’s finance ministry because its active managers underperformed their benchmarks.

But are those benchmarks rational? A new paper from Russell Investments suggests what many active investors have long thought: the “market portfolio” pioneered by Nobel Prize Laureate William Sharpe does not reflect the market, in two senses. As an investable index, the “market portfolio” may not represent all market opportunities. Nor do all investors come to the market for the same reasons.

As Russell notes: “Investors may consider alternatives if they believe markets are not fully efficient.” The great market decline of 2008 and early 2009, arguably, showcases inefficiencies. As many active managers have said, “everyone thought the world was going to end.” It didn’t, and less liquid corporate bonds and small caps recovered massively.

Then again, Russell observes: “A pension fund investor may wish to invest in a bond portfolio that matches cash flows. An endowment or foundation may have sustainable or ethical investing goals.” So not all investors have the same motivations for investing. Some are simply looking at an asset-liability match that is not delivered by an investable index; others are looking to “do good.”

Active management is not dead, at least not yet.

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