What Is an Index?

Abstract

Technological advances in telecommunications, securities exchanges, and algorithmic trading have facilitated a host of new investment products that resemble theme-based passive indexes, but depart from traditional market-cap-weighted portfolios. In this article, the author proposes broadening the definition of an index using a functional perspective. Any portfolio strategy that satisfies three properties should be considered an index: (1) it is completely transparent, (2) it is investable, and (3) it is systematic (i.e., it is entirely rules-based and involves no judgment or unique investment skill). Portfolios satisfying these properties that are not market-cap-weighted are given a new name: dynamic indices. This functional definition widens the universe of possibilities and, most importantly, decouples risk management from alpha generation. Passive strategies can and should be actively risk managed, and the author provides a simple example of how this can be achieved. Dynamic indices also create new challenges; the most significant of these is backtest bias, and the author concludes with a proposal for managing this risk.