Why Investors Should Not Follow Indexes

KNOW WHAT INVESTMENTS YOU OWN AND WHY – ALL INDEXES ARE NOT CREATED EQUAL

Overview

MOST ADVISORS AND MANY ASTUTE CLIENTS ARE AWARE OF THE FACT THAT OVER THE LAST TWENTY YEARS (ACCORDING TO THE DALBAR STUDY), EQUITY MUTUAL FUND INVESTORS HAVE NOT ONLY FAILED TO BEAT THE MARKET AS DEFINED BY THE S&P 500 BUT THEIR FUND MANAGERS HAVE ALSO TRAILED THEIR CHOSEN BENCHMARK.

This fact is undeniable and we do not refute the research that supports it. What we do take issue with is the “knee-jerk” reaction that many advisors and investors alike have taken to remedy the situation. That being, a tremendous flight from accomplished active money managers to funds that center around an indexing strategy.

ALL INDEXES ARE NOT CREATED EQUAL

Just as investors’ ability to time the moves of the market has been a failed attempt over the last twenty years, we believe that an investment strategy focused on indexing is flawed as well. Although the industry is in the process of offering alternative methods to the construction of indexes, a major percentage of indexes are still calculated using a market-capitalization method of weighting. In our paper, we present three reasons as to why this weighting scheme is flawed and thus is not an optimal investment strategy for advisors or investors alike. Lastly, we find it very interesting the fact that these new-fangled index methods of construction seem to be attempting to replicate the long-lost art of stock picking.

Granted, a step in the right direction but we will not rest our case until every investor has complete clarity and simply knows what they own and why they own it!

As complicated as the investment industry has made everything from regulation to trading, it also has convoluted the construction of market indexes.

The first stock market index was created by Charles Dow in 1896 and has come to known as the Dow Jones Industrial Average (Dow). At the time, Mr. Dow was simply trying to construct a method of tracking the overall stock market in aggregate form. His finished product was a 12-stock index that used a price-weighting method or scheme. Although cutting-edge at the time, most view this method as antiquated in nature. We say this because only the most rudimentary of investors would build a portfolio based on the absolute price of the stock. This would be indicative of a young adult who was given $2,500 as a graduation gift and wants to begin the process of investing. They want to buy Amazon or Google, but because of the enormous share price of each stock being greater than $2,500, they can only purchase one outstanding share – not a very good method of diversification. Alternatively, they have the option of taking a more prudent course and purchasing 10 shares of SiriusXM Radio, trading at $6 per share, and 10 shares of Hive Blockchain Technologies, trading at less than $2 per share and so forth. Apple per Morningstar at https://www.morningstar.com/etfs/arcx/ivv/portfolio is the largest holding in the S&P 500 at nearly a 7% weighting. In fact, if you add-up the top 10 holdings in the S&P 500, they equate to nearly 30% of the total. This means that 2% of the holdings comprise 30% of the weighting. At first glance, some would suggest that owning Apple has been a good decision – for the most part it surely has.

Three Pitfalls of Market-Cap Weighted Indexes

1. Stock Concentration Risk

Unlike a price-weighting scheme, the market-cap method weighs individual holdings not by mere price alone but by market price times the number of shares outstanding (aka market capitalization). Some refine this method by including those shares that are just actively traded in the market, which the industry refers to as free-float. Either way, this highly popular method by its sheer construction heavily overweights those of largest stature. For example, due to its popularity, according to Morningstar (https://www.morningstar.com/etfs/ arcx/ivv/portfolio) Apple is the largest holding in the S&P 500 at nearly a 7% weighting. In fact, if you add-up the top 10 holdings in the S&P 500, they equate to nearly 30% of the total. This means that 2% of the holdings comprise 30% of the weighting. At first glance, some would suggest that owning Apple has been a good decision – for the most part it surely has. However, there lies a flaw in this mentality. As a company’s market value increases (like Apple’s) so does the company’s weight in the index, as well as the investor’s exposure to that single stock or set of stocks. Here is the catch; a market index that bases its weighting-scheme solely on size will overtime systematically (upon rebalancing) invest too much in stocks that are overbought and too little in stocks that are selling at a discount to their intrinsic value. This leads to investors increasing on a percentage basis those stocks that rise in price and reducing those that drop in price. Is this not a fancy way of saying; “Buy High and Sell?” Academics refer to this dynamic as the Representative Bias where investors flock to high-flying stocks and flee those that are unwanted. Like most behavioral biases, research has shown this systematic flaw is attributable to roughly 2% of lost return on an annual basis.

2. Sector Concentration Risk

This risk became no more apparent than it did in the late 1990’s when investors fell prey to what become known as the, “Internet Stock Bubble.” This occurs when a higher percentage of stock fund inflows move to specific industries or sectors and like the previous example of individual stock concentration risk, as the values of specific sectors rise, their respective weightings in the market index portfolio rise as well. Using the technology sector in the late 1990’s as an example as internet stock prices went up in the price, market-cap weighted indexes (S&P 500) became too heavily over concentrated in this overpriced sector and consequently too underweighted in the stocks of long-standing enterprises in less alluring industries. Simply put, this ever so popular method of weighting allocates a disproportionately higher amount of capital to indus- tries that are potentially overvalued, thus leaving investors susceptible to inevitable pullbacks in a much more concentrated manner.

3. Style Concentration Risk

This is what we refer to as the “hidden risk” of indexing, as it is not as well known as the other two. Nonetheless, its effect on performance can be as devastating as its two counterparts. For example, during a market environment where growth stocks outperform value stocks, a trend like we have had over the last five years, in a market-cap weighting scheme, said growth companies get larger and subsequently increase their percentage weightings. Because of this phenomenon, value-based investors will most likely face a relative, short-term performance drag. Feeling disillusioned they may be tempted to rotate out of underpriced value stocks and move into overbought growth plays. This sets-up another potential reversal of fortune where the investor is duped into buying high and selling low.

Like King Solomon said; “There is really nothing new under the sun.” We affirm the wise King’s age-old comment by applying it to the Investment Industry’s response to the perplexing problems the market-capitalization method of indexing has caused investors. Instead of reforming their thought process by suggesting that investor return to the four pillars of sound investing principles, Philosophy, Strategy, Transparency and Flexibility that originally drove the investment process, that have chosen to develop new index weighting schemes that in our estimation aim to replicate the approach active money managers took decades ago. Recognizing that both Price and Market-weighting methods are highly flawed academics and research departments alike have engaged their respective laboratories to cook-up new methods. With all sincerity, we applaud their efforts and granted strides of progress have been made, however we find it very ironic that as each new indexing method is created it looks more and more like an attempt to replicate an active money manager. To document our skepticism, we describe the most popular new methods created over the last five years and give our opinions on their effectiveness. However, as we will detail, “There is really nothing new under the sun.”

Three New Methods of Indexing

1. Equally-Weighted Indexing

The easiest way to avoid the problem of owning too many overpriced stocks at the expense of owning too few discounted priced stocks (as a result of market-cap weighting) is to simply use an equal-weighting scheme. Equal-weighted indexes own the identical holdings of their market-cap weighted counterpart, they just own them in equal percentages as opposed to a owning them based on size. The pros of this approach are that stock, sector and style concentration are very much mitigated and that is a good thing. The cons become the constant re-balancing that is needed to keep each stock at a precise equal weighting. In addition to the heightened costs of this methodology, its biggest detriment is the fact that it totally strips away from the manager any flexibility whatsoever as it ties their hands to a constant equally weighting environment. The manager may desire, due to fundamental analysis to let certain positions rise and fall greater than the programmed re-balance trigger before a buy or sell decision is initiated. Under this weighting scheme, manager-flexibility is totally negated and thus we reject its usefulness.

2. Fundamentally-Weighted Indexing

This new method of indexing has been spearheaded by the academic community specifically, Jeremy Siegel who founded WisdomTree and Bob Arnott who founded Research Affiliates (RAFI). Both men are well respected and have served the industry with the utmost of integrity. Their goal in developing a fundamental scheme of weighting was to totally eradicate price in the process. They accomplished this mission as fundamentally weighted indexes use such measures as sales, book value, cash flow and dividends. Per information garnered at https://www.rafi.com/content/dam/rafi/documents/index- documents/factsheets/fundamental/fundamental-us-index-factsheet-usd.pdf the RAFI Fundamental US Index contains 40% of the Top Ten holdings that are in the S&P 500. One could make the case that the RAFI method of indexing is not indexing at all as defined by the Capital Asset Pricing Model (CAPM). William Sharpe in 1964 developed CAPM and assumed that the most efficient market portfolio combined all risky assets weighted by their market capitalization. Sharpe would say that anything that is not market-cap weighted is neither passive nor is it an index. Bottom line is that an improvement on methodology is noted however, we would refer this as a quant-driven, algorithmic-based process-driven fund (aka active management) as opposed to an index.

3. Formulaic Value Indexing

This is the newest form of indexing and relies on a methodology that uses deeply discounted value metrics, such as low Price Earnings ratios, high dividend yields, low Price-to-Book ratios, and high Enterprise Value to EBIDTA (Earnings before Interest, Depreciation and Amortization). The term ‘value indexing’ is increasingly being adopted by quantitative investment strategies that use ratios of common fundamental metrics (e.g., book value, earnings) to market price. A hallmark of such strategies is that they do not involve a comprehensive effort to determine the intrinsic value of the underlying securities. This was cited by three authors, Kok, Ribando and Sloan who wrote the paper “Facts About Formulaic Value Investing,” that appeared in the Journal of Financial Analysts in 2017. In that article they reference the DFA US Large Cap Value Fund (ticker DFLVX) as an example of a fund that attempts to use computers to extract what ultimately humans can do and that is unearth true business value. In review of the Fund we would agree as well as we note the following characteristics, as noted in https://www.morningstar.com/funds/xnas/dflvx/performance:

The Fund is too diluted, as it holds 371 stocks
The yield for a Value Fund is low at 1.53%
Expense Ratio at 0.22% is elevated for a Large-Cap Index product
Trailing one-year performance at 14.72% through 03/04/22 is decent, however, this is -256 basis points below the the stated Benchmark, the Morningstar US Large-Mid Broad Value Index

Why don’t fund companies who develop index products just explain to us in the name what the strategy is as opposed to spinning the name into an alluring market gimmick? No doubt there has been progress in our industry and in our estimation, the pioneers of Equal, Fundamental and Rules-based indexing styles have realized the major flaws in market-cap weighted schemes and have attempted to add a component that pushes it towards active management. On the one hand we commend their efforts but much like the aforementioned two new methods of Indexing, a Rules-based scheme provides investors with very little transparency and at the end of the day investors get flustered because they don’t understand why they own what they own.

CONCLUSION

With the advent of index-based mutual funds in the 1970s and exchange-traded funds over the last decade, the industry has made several strides in attempting to offer strategies to investors that combat the results of underperformance, as documented by the Dalbar Study. We recognize their efforts but we take issue with the results.

Many investors in market-cap weighted index funds believe they know what they own and why they own it. Yes, they know that they own 500 stocks (actual current number is 505 in the S&P 500) but what they do not know is that Apple comprises nearly 7% and that the top 10 stocks are 30% of their portfolio. Additionally, investors are most likely unaware that they have a tremendous bias towards growth stocks and overvalued sectors. Source: (https://www.morningstar.com/etfs/arcx/ivv/portfolio)

As we previously stated, the answer to this conundrum is to “build a better mousetrap” as opposed to conforming to the concept of indexing as a client investment strategy. This is heavily documented in the newly fangled ETF product line where investors may KNOW WHAT THEY OWN, but they surely DO NOT KNOW WHY THEY OWN WHAT THEY OWN. Many ETF sector funds are heavily overweighed in one or two holdings that dramatically skew performance. In addition, the nuances of the security screening process are completely foreign to even the most astute investor.

Seek a manager who provides complete clarity in their investment process, which is the pathway to meeting your goals.

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Why Investors Should Not Follow Indexes

KNOW WHAT INVESTMENTS YOU OWN AND WHY – ALL INDEXES ARE NOT CREATED EQUAL

Overview