The Lemon Fool

I was rather surprised at this headline in the FT

Passive boom sees number of market indices hit 3.7m

The article is behind a paywall, but a google search of the headline will provide access.

I was genuinely surprised at the number of indices, the number of equity indices has fallen slightly but is still around 3 million....

I know there are a lot of active funds globally but it seems the number of indices is greater by an order of magnitude!

When you discover what some of the providers are charging to use their indices then it is slighly less surprising that the industry has grown so much.
Have you noticed how many fund managers have moved away from the traditional benchmarks?

An index is really just a set of rules. The most common indices are based on market cap but that's really just one approach although is the one most investors use as a benchmark. The growth of ETFs has spurred an explosion in indices but they should probably not be seen as benchmarks but rather as high-level ideas reflected in a basket of shares that comply with the idea's inclusion rules.

In that context you'd expect a lot of indices because there are a lot of investment ideas and themes. And the number of funds in the world exceeds the number of shares by a large margin, again showing that there is no limit to the ability of the investment business to slice and dice in a near infinite number of ways.

Investors love investing by theme and idea, as many feel they can understand high-level concepts better than all the nitty gritty details of shares and companies. ETFs are not going away.

This is where I think the terms "Active" and "Passive" becomes inappropriate. Most of those indices will cover rules based trading strategies which are anything but passive according to the dictionary definition. IMHO passive/active are not the right terms for describing the difference between rules based strategies and those involving decisions made by human portfolio managers. Some rules based strategies may involve little portfolio churn, such as cap weighted indices, or be highly active, such as momentum indices. Equally, some fund managers and private investors will have very low portfolio turnover, far lower than many of these rules based strategies.

Eventually we will have portfolios managed by AI, if they don't already exist. Will these be active or passive?

hiriskpaul wrote:This is where I think the terms "Active" and "Passive" becomes inappropriate. Most of those indices will cover rules based trading strategies which are anything but passive according to the dictionary definition. IMHO passive/active are not the right terms for describing the difference between rules based strategies and those involving decisions made by human portfolio managers. Some rules based strategies may involve little portfolio churn, such as cap weighted indices, or be highly active, such as momentum indices. Equally, some fund managers and private investors will have very low portfolio turnover, far lower than many of these rules based strategies.

Eventually we will have portfolios managed by AI, if they don't already exist. Will these be active or passive?

There is no such thing as truly passive.
Even at the big index funds someone has to make a decision on when to use derivatives (which they use a lot) how close to full replication do they go, (none of them hold all the stocks in the index), how much cash to hold, when to trade on inflows and outflows.

This is a typical objective for passive fund, in this case L&G All-Share

The objective of this Fund is to provide growth by tracking the performance of
the FTSE All-Share Index.

It says nothing about how it will do it.

Well they usually say something about how an index will be tracked. Full replication, sampling or using swaps for example. But no index is passive anyway as they aĺl have to react to corporate actions and stocks moving in and out of the index, so no index fund can be truly passive either. There is a range of activity from low to very high.

Vanguard published trading costs for their index funds recently. Most were under 2bps and under 1bps for the S&P 500, but I was surprised at the cost of running the FTSE 250 fund. It was much higher than the FTSE 100.

I think what caught my attention was 3,000,000 Equity Indices.....there are (apparently) around 50,000 listed companies globally, many of these trade thinly.... the difference is an order of magnitude !

OhNoNotimAgain wrote:Even at the big index funds someone has to make a decision on when to use derivatives (which they use a lot) how close to full replication do they go, (none of them hold all the stocks in the index)

No, some index funds do hold every share in an index. It's not that hard to do for a fund tracking the FTSE-100 or the S&P 500, for instance.

I would not say that index funds and ETFs use derivatives "a lot". Some use only derivatives, some use them partially for specific purposes, and some do not use them at all. They make the most sense for ETNs and commodity ETFs, and the least sense for basic trackers of the major indices.

Moreover you say that like using derivatives is somehow bad, wrong or risky. Again, not the case. Derivatives can be used to reduce risk as well as increase it. In fact, in any derivatives trade one of the two parties involved is reducing risk.

You should also distinguish between derivatives that have credit and settlement risk, i.e. over-the-counter derivatives like swaps, and exchange-traded derivatives like options and futures.

Interesting thought - is it safer to hold a FTSE 100 futures contract, or a physically replicated FTSE 100 ETF? Arguably the futures contract is more transparent as your sole exposure and point of failure is the exchange, which typically has an AAA rating. OTOH, does the checks and balances around the ETF and the fact that there is some physical underlying somewhere make the ETF safer?

hiriskpaul wrote:Interesting thought - is it safer to hold a FTSE 100 futures contract, or a physically replicated FTSE 100 ETF? Arguably the futures contract is more transparent as your sole exposure and point of failure is the exchange, which typically has an AAA rating. OTOH, does the checks and balances around the ETF and the fact that there is some physical underlying somewhere make the ETF safer?

The risk with an OEIC lies only with its custodian bank.

An ETF has that risk and then has the additional risk of the broker or manager managing it as it has to trade constantly to match the index throughout the day so it is holding securities as well. An ETF is just a fund that is traded so there is a risk with the party holding that fund as well as the party holding the underlying securities.

Any ETF or OEIC that uses derivatives then has the additional counterparty risk of the company it is dealing with.

As the collapse of Beafourt demonstrated even investors just using a broker suddenly realised they more at risk than they realised. The more parties that are involved the higher the risk, as well as a higher cost base.

Lootman wrote:An index is really just a set of rules. The most common indices are based on market cap but that's really just one approach although is the one most investors use as a benchmark.

I think cap weighted is a bit more than just one approach. It is the logical rule to use to capture the efficient market and aggregate every market participants effect in investing in tradeable stocks.

OhNoNotimAgain wrote:

hiriskpaul wrote:Interesting thought - is it safer to hold a FTSE 100 futures contract, or a physically replicated FTSE 100 ETF? Arguably the futures contract is more transparent as your sole exposure and point of failure is the exchange, which typically has an AAA rating. OTOH, does the checks and balances around the ETF and the fact that there is some physical underlying somewhere make the ETF safer?

Any ETF or OEIC that uses derivatives then has the additional counterparty risk of the company it is dealing with.

Again you are ignoring the difference between listed derivatives and OTC derivatives.

With options and futures your counterparty is the exchange and so there effectively is no counter-party risk, unless you think that a major exchange can fail, and I cannot recall that ever happening.

I could probably construct a reasonable argument that a single futures contract is less risky than holding hundreds of shares listed on several exchanges.

Lootman wrote:

OhNoNotimAgain wrote:

hiriskpaul wrote:Interesting thought - is it safer to hold a FTSE 100 futures contract, or a physically replicated FTSE 100 ETF? Arguably the futures contract is more transparent as your sole exposure and point of failure is the exchange, which typically has an AAA rating. OTOH, does the checks and balances around the ETF and the fact that there is some physical underlying somewhere make the ETF safer?

Any ETF or OEIC that uses derivatives then has the additional counterparty risk of the company it is dealing with.

Again you are ignoring the difference between listed derivatives and OTC derivatives.

With options and futures your counterparty is the exchange and so there effectively is no counter-party risk, unless you think that a major exchange can fail, and I cannot recall that ever happening.

I could probably construct a reasonable argument that a single futures contract is less risky than holding hundreds of shares listed on several exchanges.

There is always risk, and the more counterparties involved the greater the risk and an increased workload in managing it.

OhNoNotimAgain wrote:

Lootman wrote:

OhNoNotimAgain wrote:Any ETF or OEIC that uses derivatives then has the additional counterparty risk of the company it is dealing with.

Again you are ignoring the difference between listed derivatives and OTC derivatives.

With options and futures your counterparty is the exchange and so there effectively is no counter-party risk, unless you think that a major exchange can fail, and I cannot recall that ever happening.

I could probably construct a reasonable argument that a single futures contract is less risky than holding hundreds of shares listed on several exchanges.

There is always risk, and the more counterparties involved the greater the risk and an increased workload in managing it.

Again, not true, several counterparties with effectively zero risk (e.g. an exchange) are safer than one counterparty with some credit risk.

You are not making any effort to assess the credit quality of counterparties; you are merely counting them.

There are trillions of dollars in ETFs out there. I am not aware that any ETF has failed or suffered a total loss because of this "risk" that you claim.

Lootman wrote:

OhNoNotimAgain wrote:

Lootman wrote:Again you are ignoring the difference between listed derivatives and OTC derivatives.

With options and futures your counterparty is the exchange and so there effectively is no counter-party risk, unless you think that a major exchange can fail, and I cannot recall that ever happening.

I could probably construct a reasonable argument that a single futures contract is less risky than holding hundreds of shares listed on several exchanges.

There is always risk, and the more counterparties involved the greater the risk and an increased workload in managing it.

Again, not true, several counterparties with effectively zero risk (e.g. an exchange) are safer than one counterparty with some credit risk.

You are not making any effort to assess the credit quality of counterparties; you are merely counting them.

There are trillions of dollars in ETFs out there. I am not aware that any ETF has failed or suffered a total loss because of this "risk" that you claim.

That's probably what Goldman Sachs said to Hank Greenberg of American International in 2007 about underwriting secondhand mortgages.

OhNoNotimAgain wrote:

Lootman wrote:

OhNoNotimAgain wrote:There is always risk, and the more counterparties involved the greater the risk and an increased workload in managing it.

Again, not true, several counterparties with effectively zero risk (e.g. an exchange) are safer than one counterparty with some credit risk.

You are not making any effort to assess the credit quality of counterparties; you are merely counting them.

There are trillions of dollars in ETFs out there. I am not aware that any ETF has failed or suffered a total loss because of this "risk" that you claim.

That's probably what Goldman Sachs said to Hank Greenberg of American International in 2007 about underwriting secondhand mortgages.

That is an utter non sequitur and you know it.

Lootman wrote:

OhNoNotimAgain wrote:

Lootman wrote:Again, not true, several counterparties with effectively zero risk (e.g. an exchange) are safer than one counterparty with some credit risk.

You are not making any effort to assess the credit quality of counterparties; you are merely counting them.

There are trillions of dollars in ETFs out there. I am not aware that any ETF has failed or suffered a total loss because of this "risk" that you claim.

That's probably what Goldman Sachs said to Hank Greenberg of American International in 2007 about underwriting secondhand mortgages.

That is an utter non sequitur and you know it.

No its not. You quoted the Titanic excuse that something was safe because it was big and it hadn't gone wrong before. I quoted an example where big things can go wrong even if they haven't before.

Lootman is totally correct. When assessing credit risk, it is not the number of counterparties that matters, but aggregate credit risk. Having small positions in half a dozen exchange traded futures is far less risky than say a large position in a single OTC derivative with one bank.

Saying credit risk increases with the number of counterparties is like saying market risk increases as you add more securities to a portfolio.

hiriskpaul wrote:Lootman is totally correct. When assessing credit risk, it is not the number of counterparties that matters, but aggregate credit risk. Having small positions in half a dozen exchange traded futures is far less risky than say a large position in a single OTC derivative with one bank.

Saying credit risk increases with the number of counterparties is like saying market risk increases as you add more securities to a portfolio.

Well I disagree with that because of the domino effect. Counterparties are linked by obligations in a way that does not apply to the connection between different equities that are in different industries and sectors.

Central banks monitor banks because they are interlinked. They don't supervise builders and retailers.

Risk managers are well aware of domino effects! I also still maintain that exposure to an AAA rated exchange, with all positions continuously margined is still much lower risk than exposure against a single counterparty such as a bank. To argue otherwise is to argue against the entire basis of diversification, insurance and financial exchanges.

If you think your risk is with an exchange you are looking in the wrong place.

Ps central bank monitoring of banks has worked very well in the past hasn't it?