The Third Wave of Indexing

Targeted index funds are coming.

John Rekenthaler 23 May, 2016 | 12:06
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Three's Company
The first wave was replication. Index funds copied the U.S. stock market, European stock markets, the investment-grade bond market, and so forth. Those were the early entrants, and they became the dominant entrants. Currently, the vast majority of indexed assets are with market replicators. For most investors, such funds are synonymous with the term "indexing."

The second wave brought tilting. In 1981, Dimensional Fund Advisors decided that if small-value stocks would outgain other stocks, as its research suggested, then perhaps funds should limit themselves to the small-value segment. The company created indexes to match its beliefs, and then funds for those indexes. The practice of factor indexing--that is, indexing by restricting the portfolio to securities that are exposed to one or more investment "factors"--had begun.

Tilting was far from an instant success. DFA spent its first decade in obscurity, and its second as a cult film. It was not until the 2000s that tilting attracted widespread attraction. This came not only because DFA funds had performed well, but also because tilting became branded, as "smart beta." The Greek word beta meant exposure to factors. But these betas would not be just any betas. They would be special betas. They would be smart betas. (A term that Morningstar rejects, in favor of the more-neutral phrase "strategic beta.")

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John Rekenthaler  is vice president of research for Morningstar.

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