Words matter.
The reason we are still having the inane active vs. passive debate is due in large part to the awkward framing of the question. A better debate would be over high cost vs low cost investment solutions.
The same issue is playing out with the word ‘index.’ A few months ago I wrote a post about how our understanding of the word ‘index’ has changed from a broad-based measure of the performance of an asset class into pretty much any old method for picking stocks. The best analogy I can think of, is that these ‘indices’ are as different as clothes that are ‘off the rack‘ versus those that are bespoke. They’re both clothes, but different as can be.
For those whose understand the differences, it is not a big deal. However for the broader public it can be confusing. It can even be confusing for professionals. Here’s the rub. No one is forcing anyone to invest in an index fund, of any type. Not only that, fund companies can change the index a fund uses, if it so desires.
Yes, you can argue that if you are participant in a 401(k) plan and the only investment options are index funds, then yes, I suppose you are being forced to invest in an index. For example, the federal government’s TSP comes to mind.
There are plenty of reasons to be skeptical about the proliferation of indices. However it seems counterproductive to try and limit their development. Should index providers be ‘transparent and accountable’? Absolutely, but as I wrote a while back the beauty of ETFs, and by extension the many indices that underlie their strategies, is the many attempts at experimentation and innovation.
Someone will come up with better terms to distinguish between broad based indices and their bespoke cousins. Until then, know what you own.
Update: John Rekenthaler at Morningstar has a good take on the potential risks of self-indexing. See also Ben Johnson talking about the evolving nature of indices.
