Active changes to passive indices

SPEAKER_1 (0:00)

What we want to maximize is not expected return, it's not expected wealth.

It's some kind of risk-adjusted wealth or risk-adjusted return. And we all know that, but we have to be really careful that we don't fall into a trap of maximizing expected value or expected money or expected return.

SPEAKER_2 (0:20)

To hear more about managing risk in the face of uncertainty, subscribe to P-Gym's The Outthinking Investor in your favourite podcast app.

SPEAKER_1 (0:36)

Pushkin.

Katie Martin (0:39)

Are markets up or down today? Well, everyone figures that out pretty much the same way. You look at an index, where's the S&P 500? Where is the MSCI world? What's it doing? If you really fancy it, you can look at where the FTSE 100 is trading.

These things, everyone knows this right. Indices are neutral, they're dispassionate, they're objective measures of what markets are doing.

Right?

SPEAKER_4 (0:59)

You know, not quite.

Katie Martin (1:01)

Today on the show, we're here to tell you, indices are not as neutral as you think, and we should probably all think about them a lot more than we currently do.

This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin. I'm markets columnist Katie Martin, and to chew through all this, I'm joined by FT contributing editor, brain box, and fellow pretentious indie music fan, Toby Nangle.

Toby Nangle (1:24)

How do I respond to that, Katie?

Katie Martin (1:26)

I mean, you could respond by telling me what you think the most underrated album of 1996 was.

Toby Nangle (1:33)

Katie, you're making my life very difficult here.

Katie Martin (1:37)

I'm not sure what year Elastica by Elastica came out. I think it might have been 1996, and that's a criminally underrated album for my money. Anyway, we're going to bore the youth if we carry on with this.

Toby, you used to have a proper job, right? You used to be a fund manager.

Toby Nangle (1:51)

Yeah, that's right. For 25 years, I was a fixed income then asset allocation fund manager.

Gave it all up a couple of years ago.

Katie Martin (1:59)

So, when you're doing that job day to day, how important are indices and also indices or indexes, which do you prefer?

Toby Nangle (2:07)

Let's go for indices. Okay. Yeah, the index is pretty important, not because you necessarily want to be an index hugger. When your client gives you, let's say, a billion dollars to try and beat a particular benchmark, Quite a lot of money.

Could be quite a lot of money, yeah. Then you might have this idea about, here are all the things I really want to buy. These are fantastic things.

But if the things which you're being measured against, go in a completely different direction, then you're going to have to have half an eye to that, right?

Katie Martin (2:33)

Yeah, yeah.

Toby Nangle (2:34)

So you'll have a risk department, risk manager saying, you know, you've got this risk budget, how much do you really want to spend on this stuff that you like versus this other stuff about which you have no opinion? Just buy it.

Katie Martin (2:45)

So in real life, this person who's given you a billion dollars or like the person in the street who's just like looking at how fund managers perform, ultimately, they look at the S&P 500 and they say, well, US stocks have done X. Can you beat that? Can you not beat that? Because if you can't beat that, I can just buy the index for basically free. So it really, you know, it's a really hard yardstick, right?

Toby Nangle (3:08)

Yeah, yeah, absolutely. I remember actually, I mean, back in the day when I was managing high-yield bonds, one of the trickiest, weirdest times was when WorldCom, do you remember WorldCom? Huge massive US telecom company starts to go down in flames, but it doesn't go completely down in flames in one go. It goes from investment grade and then it went into the high-yield debt universe and at 50 cents in the dollar, made up like 10% of the market.

Katie Martin (3:34)

Right.

Toby Nangle (3:35)

And so it becomes hugely binary. And so it comes a question of risk management. Do you buy the stuff that you think is probably going to go bust?

Because if it doesn't, then your career is over.

Katie Martin (3:44)

Yeah.

Toby Nangle (3:45)

That sort of decision. Yeah. So indices are hugely important for active managers, as well as passive people or robots who just have to press the button and buy. Press the button.

Katie Martin (3:53)

And so I think there's a kind of generalisation and there's a kind of general idea out there that indices, they are these neutral benchmarks. But the thing is, there's no such thing, right? Somewhere, a human has to decide what goes into an index and what doesn't. Like really, how much discretion is involved here?