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A Myth of Index Investing

Published on: Jul 14 2016

Most people refer to index fund investing as passive investing. They say that the fund or other investment vehicle isn’t actively selecting stocks or other investments. That’s wrong, as this article points out. While there is such as a thing as “the market,” there’s nothing that tells an investor how to invest in “the market.” So, we have firms construct indexes or other benchmarks of the market and compare actively-managed investments to the index. But indexes aren’t constructed by people, and they are making judgments about companies and stocks. Indexes are actively-managed investments. The real puzzle of investing is why so few active investors consistently do better than these actively-managed indexes.

But there is a degree of subjectivity that goes into developing a benchmark index, particularly when deciding on contentious issues, such as which countries to classify as developed, emerging and frontier.

MSCI’s decision to leave domestic Chinese equities out of its global gauges in June surprised many forecasters, while its upgrade of Pakistan to emerging-market status the same month sent shares in Karachi surging to a record — a sign that investors had failed to price in the move. MSCI didn’t respond to requests for comment for this story.

Beyond market classification decisions, stocks routinely rise or fall when index providers announce even small adjustments to their most widely-followed gauges.

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