The Hidden Flaws of Index Investing

Index investing has become so popular over the past few years that it has nearly become a household name. It seems you can’t read anything online or in financial print that doesn’t highlight the virtues of index mutual funds as the primary investment vehicle in portfolios. The main thrust of those stories shows how index funds are a better long-term investment than actively managed mutual funds. The reasons have been well-documented: Nearly 70% of actively managed funds fail to outperform their comparative market index. This is the statistic many investors read seemingly each day.

The Standard & Poor’s 500 Index is one of the most popular market indexes in the world and is often used to measure the performance of most actively managed domestic large company fund managers. But is it a fair comparison?

Background on Index vs. Actively Managed Investing

Index funds seek to replicate the performance of a specific index—generally an equity and/or fixed income (bond) index by investing in the same or similar percentages of that particular index. Index funds can include both mutual funds and exchange traded funds (ETFs). The largest index fund on the planet happens to be the State Street Global S & P 500 Index ETF, known as SPDR (pronounced like spider). Index funds have one striking advantage over actively managed funds—significantly lower operating expense ratios.

Actively managed funds do not necessarily seek to replicate the performance of an index, although they certainly can. There is a human element involved whereby a single manager or management team selects the individual securities. They rely on quantitative as well as qualitative factors to decide how to construct their fund. With active management, investors believe they can identify managers who can “outperform” their respective passive market index over time. This is the allure of active management, the chance to outperform its passive index counterpart. (For related reading, see: Active Management: Is It Working for You?)

A Closer Look at the S&P 500 Index

I started with a question: Is it fair to compare an index like the S & P 500 Index to actively managed large company mutual funds? Before I answer that question, it would be educational to take a closer look at the S & P 500 Index. This index is capitalization-weighted (defined as stock price times shares outstanding), which means the highest weighted stocks would have the most influence on performance, either up or down. As an example, literally three stocks comprise 10% of the entire index—Microsoft, Apple and Google. These three well-known companies happen to be valued the highest. To get to the top 20% of the index, you would only have to add another seven stocks to the mix. If you add another nine stocks, then you’d get to 30% of the index. I think you get the picture. The bottom line is, it certainly doesn’t seem to be as diversified as advertised, and its performance can be driven by only a handful of stocks at any given time.

A bull market in large company stocks that started in March 2009 has turned this index into the de-facto market benchmark, having gone up over 200% over that period, and is probably why many investors have been pouring money into it. If an actively managed large company fund does not own one or even several of the largest stocks in the index, and those stocks happen to perform well, as they have since 2009, then it would not be surprising to see those managers underperform. 

I’m not saying that investors should avoid using index funds because of the way they are structured, because not all index funds use market capitalization to weight their holdings. For example, some index funds and exchange traded funds (ETFs) use equal-weight, while some use other enhanced indexing methods. However, it is important for investors to understand how these indexes are constructed to properly measure performance against an actively managed fund. (For related reading, see: 3 Types of Indexing for ETF Success.)

Furthermore, there may be a false sense of security with index investing because everyone is writing about how great they are over the long-term, without realizing they have their negatives, like when only a handful of stocks drop significantly causing the index to drop when least expected. Investors need to know what they own and why they own it at all times. This will help them make better decisions while not allowing newspaper and magazine articles to do so for them.

Ultimately, investors should not rely too heavily on only one or two index funds to meet their objectives, but rather, they should rely on a more diversified approach using more than domestic large cap stocks. I believe that too many investors focus too much of their overall portfolio’s performance on whether it is keeping up with one or two indexes like the S&P 500 Index. If an investor is measuring performance based on such a narrow index like the S&P 500 Index, then they will be unhappy to see how poorly their own portfolio performs when just a few stocks are driving the index fund. Comparing a portfolio with many asset classes to that of a narrow index like an S&P 500 Index fund is unfair.

Successful, long-term investing includes owning a variety of asset classes around the globe. Doing so alleviates relying too heavily on just one area of the market. (For related reading, see: The Importance of Diversification.)

 

 

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