Indexing confronts uncertainty principle

The international newspaper of money management March 19, 2007

Posted: February 19, 2007, 6:01 AM EST

By Seymour N. Lotsoff

In 1927 Werner Heisenberg introduced the Heisenberg Uncertainty Principle in one of the foundation papers of quantum mechanics. He was awarded the Nobel Prize in physics primarily because of it. The HUP might appear to have nothing to do with investing. But I believe the HUP is as critical to the strong disagreements about indexation as it was to quantum mechanics.

Simply put, the "uncertainty principle" states that any and every measurement process affects and alters the state of any entity being measured. One cannot, therefore, ever know at any given moment with certainty all there is to know because the measurement process must in itself alter those statistics.

The HUP becomes important whenever the interaction energy is large enough to significantly affect the state of the object under observation. And that is exactly what I believe has happened in the equity markets because of indexation.

A HUP for financial markets suggests one can't invest in the market without altering the market.

The headlong rush into indexation is a self-defeating investment fad, not a lasting model. Markets always correct the excesses of fads and bubbles. Indexation will always have its appropriate applications, but its adherents will be less numerous and less enthusiastic.

Gradually, substantial advantage will accrue to investors who allocate capital to the best companies while avoiding the worst. Demanding manager tracking error to an index will be slowly discarded. Managers will look more like Warren Buffett in concept and monitoring managers like him will require much greater sophistication and more in-depth communication.

There is no doubt that a modest amount of money invested in an idealized index will have little impact.

But as indexing becomes dominant, capital markets lose their effectiveness as risk capital allocators. The consequences of widespread portfolio indexation would include:

cthe end of new public issues;

cthe end of public markets as an efficient means of allocating capital. The growth of the economy as a whole would slow to an important degree and the index returns would fall. No one would beat the market, but no one may care; and

cthe excessive overpricing or underpricing of just about every stock as the balancing between informed buyers and sellers for individual issues would cease to exist.

Fortunately everyone does not index.

Advocates of nearly universal indexing refer to $3 trillion in capitalization-weighted index funds as a measure of their argument's strength. That number is a measure of trouble.

The current size of indexed assets is understated. It misses assets involved in the enhanced index programs. It does not take into account "closet" indexing, or active managers who operate with very low tracking error mandates that effectively require 90%-plus indexing. It does not take into account index derivatives that require substantial index hedging of the derivative provider's risk.

Also, the flood of money from individual investors and financial planners into a variety of exchange-traded index funds has further extended the influence of indexation on market characteristics.

We may be nearer to self-defeating conditions than generally thought, as shown by a number of observable index distortion symptoms.

Significant mispricing of index stocks: Capitalization-weighted indexing has come under fire for overweighting overvalued stocks but index proponents claim this to be a temporary problem. The evidence indicates the opposite. There are many classic examples, such as Royal Dutch Petroleum Co. (in the Standard & Poor's 500 index) consistently trading at a 5% to 20% premium over Shell Transport & Trading Co. (not in the index) until the two issues were combined in 2005 to create Royal Dutch Shell PLC. (Foreign companies were removed from the S&P 500 in 2002.) Since then the greater use of indexation could only mean distortions have gotten worse.

The huge arbitrage opportunities associated with being long new index members and being short those issues about to be ejected provide another measure of index market distortion.

In short, the argument for moving more to active management and away from indexing is powerful. That means hard work for investors. But an efficiently functioning economy and sound money management require it.

Seymour N. Lotsoff is senior managing director, Lotsoff Capital Management, Chicago.