The number of indices available to investors has risen exponentially in the past few years, from less than 1000 in 2012 to well over a million today, a period that has also witnessed a sharp increase in assets invested in products that track indices, including ETFs. To put the number of indices that now exist into context, the World Bank estimates there are only 43,000 stocks listed globally, and this number shrinks to around 3,000 if you are looking for something highly liquid to trade.

There are (way) more indices in the world than stocks (Source: Wurgler (2011), FT, Scientific Beta, Worldbank, Bernstein analysis)

This striking finding is highlighted in a recent report from Bernstein entitled ‘Fund Management Strategy: A million indices, the death of benchmarking and the passive singularity’, in which the authors note that they “watch with amusement and despair as people find new ways to rearrange the same list of stocks”.

The report goes on to evaluate the impact of index proliferation on the asset management industry. Far from representing a triumph of indices, Bernstein argues that this growth, in fact, signals the “last hurrah” of benchmarking as we know it.

One million indices

Bernstein believes that the number of indices has risen so dramatically in the last few years because of high perceived demand and lack of barriers to entry. There has been a near-universal adoption of benchmarking in the asset management industry, both in the continuing rise in passive assets and for measuring the performance of active managers.

In the last few years, there has also been an explosion of factor investment products, also known as smart beta, that has led to the commoditisation of factor-based strategies and indices. Alongside these trends, it has become apparent that barriers to entry for index creation are now almost negligible. The marginal cost of maintaining an index for an established provider with appropriate systems in place is next to nothing.

Add all this up and you are left with the current situation in the asset management industry, where investors have the choice of well over a million indices composed of different variations of a comparatively small universe of stocks, a condition Bernstein describes as ‘an absurd super-abundance’.

Active and passive managers

So, what does this super-abundance of benchmarks mean for active and passive managers? Bernstein argues that both will be challenged by the rising number of indices.

Active managers are well aware of the threat of passive management, but the report takes the view that they do not sufficiently grasp that the commoditisation of factor strategies means they now face a multitude of benchmarks. It is no longer good enough to beat a market-cap index, they must now outperform cheap factor indices as well. Active managers must increasingly demonstrate that they can offer something not available in the thousands (or millions) or possible substitute indices.

Passive managers face challenges as well. With so many indices to choose from, passive managers must confront the question of who gets to choose the index. The act of factor or asset allocation is unavoidably active, and the importance of these decisions in determining eventual portfolio returns is well known. Can passive managers own this process too? Will active management become increasingly about selecting an appropriate portfolio of indices?

The death of benchmarking?

The report goes on to say that in other fields of human endeavour, if the number of buckets for classification far exceed the number of entities being classified then people will conclude the approach to classification is simply not useful and drop it. While this statement might seem to make sense at first glance, it is a somewhat disingenuous comparison to view an index merely as an effort to classify stocks, rather than, as in the case of many factor strategies, for example, an attempt to construct a portfolio to produce a specific outcome. Furthermore, this apparent shortcoming is not exclusive to indices – there are also many more active funds, and for that matter analysts, than there are liquid stocks.

Bernstein’s opinion is that the exponential proliferation of indices signals the final act of a mode of investing that is going away. As the number of indices has grown, the increasingly vast choice investors have when deciding the correct benchmark to track will force them to realise that active versus passive is really a question of implementation, not strategy.

The act of passive investing is never truly passive, and Bernstein argues that the importance of asset allocation has been masked by the fact that equity, bond and credit markets have all risen over the past 35 years in an extraordinary process of asset price inflation. A future of low returns would bring asset allocation sharply into focus and expose the myth of purely passive investing.

The report concludes by stating that client outcomes are what matter. Beating a benchmark does not mean that the benchmark was important for the client aim or the weight given to it appropriate. A low return world will thrust asset allocation into the limelight, especially if returns in capital markets fall below growth liabilities in the real world. Bernstein argues it would be more fruitful to pay for allocation and implementation in proportion to how they aid client outcomes, implying new fee structures, different targets for asset managers, and new thinking on the part of asset owners.