Arthur Frank: What is a stock index?

What is a stock index? The article points out that even before Modern Portfolio Theory (MPT) took off, indices were already being used as a standard to measure the overall market trends. Little did we know that 50 years later, they would become the most desired investment portfolios for investors? MPT suggests that "every investor should more or less own the entire market." If an investor owns a market-wide portfolio, their expected return should match the risk-free rate, with the entire market growing alongside economic growth.

The logic behind holding index funds (ETFs) is to spread risk across different stocks. 

But on the flip side,this means investors give up their ability to judge individual companies, unable to decide on the distribution of industries and companies within the index. This puts investors in a passive position. However, today, index investing doesn’t necessarily mean passive investing. Index funds can also play a hedging role in an overall investment portfolio.

In "The Clash of Cultures," index funds are described as buying and holding a diversified portfolio of stocks/bonds and then arbitrarily selling, or using narrower investment portfolios, or even highly leveraged portfolios to amplify the betting effect. Simply put, index fund investing faces the same contradiction between long-term investing and short-term speculation.

Currently, global index funds (ETFs) have a scale of over $5 trillion. Fund companies, sensing strong investor demand and commercial opportunities, are continuously launching innovative products, known as Smart Beta ETFs.

Smart Beta ETFs are built using factor models, similar to the ones we’ve discussed. They use risk factors like value, growth, quality, dividends, size, and momentum to construct indexed investment portfolios. The goal is to break through the traditional ETF construction methods and find non-market cap-weighted portfolios to earn excess returns and outperform the market index. We first "actively" select risk factors and then "passively" accept the returns of these portfolios. So, can ETFs still be considered passive investments in this case?

The truth is, only by understanding the index components and risk factors of the ETF can we reflect the relationship between the ETF's risk and return. These methods help us bet within a certain range because we don’t want to miss any stock within that range that might create excellent returns.

Should investors rely on index funds? My viewpoint is against it. I believe that index funds cause investors, professional managers, and even management teams to shift their focus from the essence of company operations to performance ratios, emphasizing short-term performance over the long term and affecting the overall market development. From another perspective, the performance of listed companies is originally a tug-of-war among these three forces, seeking a balance point among them.

So, I agree that for investors without the time, energy, or sufficient financial knowledge, index investing is the best strategy. But I believe the best strategy for pure index investing is to return to a traditional, simple investment strategy, which mimics the overall market with a balanced stock-bond portfolio and holds it for the long term.

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