JOI: When do you think an index becomes too active?
Prestbo: It becomes too active if the investor can't anticipate what's going to happen next with the index in terms of its composition, weighting or whatever moving parts are involved in it. The essence of active investing is you give your money to somebody and they play with it without you knowing what they're doing precisely. So far, all of the "active-ish" or strategic indexes have rules that theoretically you could follow and produce a similar result. As long as there's that transparency, then I think you're still safely in the indexing realm. Once you get into trusting, then you're in the active realm.
JOI: Where do you stand on alternatively weighted or fundamentally weighted methodologies?
Prestbo: I think there are only two things in indexing that really make a difference. One of them is selection of the components and the other is weighting of those components. What fundamental indexing does, simply, is take the selections and weight them according to something other than market cap or price or whatever. It's just a different scale on which to arrange your weighting schematic.
I have no problem with the concept. What I think is not totally clear is the relationship between those weighting schemes and market performance, and I think that's simply because we haven't had enough time yet and enough different market conditions to test the concept. I have no problem with the theory. The practice, I think, is still to be proven.
JOI: Are there any trends within indexing or index-based investing that you think need to die quick deaths or that you see as potentially harmful to investors?
Prestbo: I have nothing against the proliferation of indexes—notice how carefully I said that—nonetheless, I think the danger is that investors will get themselves into something that they really don't know how to handle. The most prominent example of that so far has been the inverse ETFs. Those are daily trading vehicles that are not a buy-and-hold kind of investment. I know that doesn't have much to do with indexing, but it does in a way, because they're taking brand-name indexes and saying, "When they go down, you can make money, too." That's very appealing to people, but they don't know how to use them, or they learn how to use them in a very expensive way.
I think the danger is that a lot of products will be launched that will be appealing to certain people who have no way of putting them in their proper place within their portfolios because they don't understand them. The more convoluted and esoteric these index vehicles become, the greater the danger that more people will slip on the banana peel and say, "Indexing is verstunken—look what happened to me." But they just didn't use them correctly.
JOI: Is all the talk about volatility just hype, or do you think investors should really care about it?
Prestbo: Volatility is just another name for risk. Risk is lots of things, but volatility is one form of risk—and it's the most easily quantifiable form. Yes, I think investors ought to be aware of it, but I don't think they ought to be scared to death of it, because risk is what enables them to make money. If everything were risk free, there would be no returns. Risk is not the enemy—it just has to be managed. And managed how? Well, managed in relation to your own risk tolerance, whether that be emotional or reality based, because of your time frame, or something else. You just have to be aware of it and construct your portfolio accordingly. But without risk, there's no investing.