Why Investors Should Not Follow Indexes
KNOW WHAT INVESTMENTS YOU OWN AND WHY – ALL INDEXES ARE NOT CREATED EQUAL
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!
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.
1. Stock Concentration Risk
2. Sector Concentration Risk
3. Style Concentration Risk
Three New Methods of Indexing
1. Equally-Weighted Indexing
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
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)