The black box:

In science and engineering, a black box is a device, system or object which can be viewed in terms of its input and output but without any knowledge of its internal workings. Its implementation is “opaque” (black). Almost anything might be referred to as a black box: a transistor, an algorithm, or the human brain.

The opposite of a black box is a system where the inner components or logic are available for inspection, which is sometimes known as a clear box, a glass box, or a white box.

Almost all investment programs are actually a black box. That is, the investment manager may allow the investor to see the holdings, but most investment strategies have many parts and parameters that are undisclosed to the public or even its investors. There is strong logic behind not disclosing ones intellectual property beyond the obvious. And, it isn’t just about intellectual property, it may be a fiduciary issue, too. When the public knows what a portfolio manager is going to do in advance, other portfolio managers can front-run the trade. Just ask Russell whose indexes are more transparent and we believe they’ve had issues because of it. I think a portfolio manager has an obligation to avoid that. And,  it just makes sense.

We can say the same for stock indexes like the Dow Jones Industrial Average or other Standard & Poors indexes. By now, it is public knowledge that the committee that oversees the Dow Jones Industrial Average has made 6 significant changes to the 30 stocks that make up the index. The Index Committee dropped Alcoa, Hewlett-Packard, and Bank of America, and added Goldman Sachs, Nike and Visa. Did you know in advance they would do that? We didn’t know until after they announced it. Why? because it’s something a committee decided. As we defined above, what is going on in the human brain is a black box. When people are going to make decisions, we can’t determine for sure in advance what the output will be.

Though we can’t actually invest in an index directly, index investors and traders gain exposure to indexes through index funds like exchange traded funds (ETFs). We say that ETFs allow us to gain exposure to a market, sector, country, etc. in a low-cost, transparent, and efficient format. But, the transparency is in regard to the index holdings and maybe the universe they select from, but not necessarily how they decide to add and delete holdings (causing the index ETF we may own to buy and sell the underlying stocks, bonds, etc.).

Is that process a black box? Yes, it is.

We know only parts of the input, we know the output, but we don’t actually know in advance the inner workings of the decision. An index like the Dow Jones Industrial Average is a system that can be understood in terms of its input and output, but not necessarily any knowledge of its internal workings. In the recent case of the Dow Jones Industrial Average, the changes will take effect with the close of trading on Sept. 20th. According to the Wall Street Journal, it was explained in a statement:

“we were prompted by the low stock price of the three companies slated for removal and the Index Committee’s desire to diversify the sector and industry group representation of the index,” S&P Dow Jones Indices LLC, the company that oversees the Dow”

Only the “low price” part of that is rules-based. The Index Committee made the decisions to reflect their desire. That doesn’t seem different from an “Investment” Committee that makes such decisions for a fund or other investment program. It isn’t.

What do you really know about indexes? We know the Dow is a price-weighted index, meaning the bigger the stock price, the larger the position for the stock, and vice versa. That is different from indexes such as the Standard & Poor’s 500, which are weighted by components’ market capitalization. But, we don’t know enough about how the Index Committee makes its decisions to have known in advance what stocks they will change. If we did know that, we could buy the new stocks and sell the outgoing stocks in advance of their announcement. That’s one reason they don’t publish it. However, the black box index goes beyond that. They couldn’t publish it before they decide the changes – they didn’t know either what the output would be until the committee members gave their input. Though many indexes may appear more quantitative (systematic decisions based on predefined rules) they are just as qualitative based on judgement and opinion (an Index Committee makes the decisions, so you don’t actually know what they’ll decide – it isn’t so “rules-based”). My point is: we couldn’t have known the outcome in advance because there was an internal meeting involved to decide.

But an index fund investor doesn’t really need to know this information in advance. Neither does an investor in any investment program. That’s why they are an “investor”. If they are a “portfolio manager” or “trader” they can do it themselves and make their own decisions deciding every little detail. When we choose to invest in any fund, index or not, we necessarily leave part of the process to the deemed expert. In the case of the index, the expert is the index provider like S&P Dow Jones Indices.

The Dow Jones Industrial Average index is totally transparent in regard to its holdings, but a black box in regard to how the additions and deletions are decided.

Stay tuned: I’ll get into this more next week…

To learn more about the Dow Jones Industrial Average, visit its learning center which shows the Ins & Outs of the Dow since 1896 and read Dow Jones Industrial Average Historical Components.