Even a casual observer of the investment landscape will realize that passive assets under management have grown dramatically, taking share from active managers.2 The reasons for this are well known and well established, and spring from the inherent performance advantages that attend passive management. Both theoretical argument3 and empirical observation4 make it clear that most active managers fail most of the time, and that outperformance, when it occurs, tends not to persist.
What the casual observer might not know is that passive management has itself come to encompass an increasing variety of indices. The earliest generation of index funds was designed to track capitalization-weighted indices that represent an entire asset class—most prominent among them the S&P 500®. A second generation of equity indices reflected subdivisions and extensions of the first generation—subdivisions into sectors and industries, and extensions down the capitalization scale. As with the first generation, the second was designed to replicate the returns of an asset class (a more specialized asset class, granted, but still an asset class), and second-generation indices were also typically capitalization-weighted. In addition, indexing spread from equities to fixed income securities and commodities.
Today most equity index development is focused not on asset class replication but on what we prefer to call factor indexing. 5 Factor indices are designed to give their users exposure to a particular pattern of returns or, more generally, to a quality or attribute with which excess returns have historically been associated.6 S&P DJI’s ongoing research initiatives for 2017 fall squarely within this set of developments, emphasizing:
• Factor/smart beta indices
• ESG (environmental, social, governance) indices
• Fixed income indices
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