Index Investing Is a Delusion

It is billed as passive investing, but nothing could be further from the truth

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Feb 22, 2017
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“Illusion is an impression that, though false, is entertained provisionally on the recommendation of the senses or the imagination, but awaits full acceptance and may not influence action.

“Delusion is a belief that, though false, has been surrendered to and accepted by the whole mind as a truth.” – From dictionary.com/thesaurus.com

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I’ve been in this business through more market cycles than I care to remember. And I can tell you from experience that every time a bull market has been in evidence for a number of years, index investing is always touted by the big mutual fund companies and ETF companies (usually one and the same) that offer such products as well as most new-to-the-business financial journalists.

Their reasoning seems convincing at first: “Why try to beat the market?” “Only 20% of all active mutual funds or investment advisers beat the market.” (Or 25% or 30% or whatever the most recent scholarly tome reports.) “Active funds charge higher fees than passive index funds.” Etc.

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The presumption underlying these statements is that it is best to sit quietly in the back seat of the car and let the adults of the investing world do your driving for you. I see three problems with this approach.

Problem No. 1: Index funds are managed by a committee in order to be “reflective” of the current economy and the sectors that drive it. Stocks that don’t perform are often dumped, and newer companies with greater momentum are added by the indexes’ holdings committees. As long as companies perform, they stay in. If they don’t, they are sold. Examples below.

Problem No. 2: In a bull market, passive investors in the most popular index funds are actually chasing momentum. With every passing day in the life of the bull, a capitalization-weighted index like the Standard & Poor's 500 inevitably places more emphasis on the most popular companies. As more buyers buy those most popular and raise the price of the component companies, the index fund is increasingly composed of high price-earnings (P/E), high price-book (P/B) and high price-sales (P/S) firms. We can call it passive, but it is neither value-driven nor conservative at this point.

Problem No. 3: The biggest problem I see with passive index investing is that its sole goal is to equal the market. That may be laudable in a rising market but unless you want to ride the roller coaster right back down again in a bear market, you need to make the active decision about when to get out. Is this decline a head fake? Is this one the real thing? Should I hold until it hits 20% down or take my cash out today?

The goal of successful investing should not be “to beat the market” but rather to make steady progress in reaching your goals. From October 2007 to March 2009, when the market declined 50%, you “beat the market” if you were down only 48%. This is a goal? You’re happy if you lose less than the 50% decline index funds endured – but still lost nearly half your invested net worth? That’s just insane.

Yet people are told to just hang in there because the market always comes back and no one can time it. “If you miss the five best days” blah blah blah. It’s true; it always does come back – just maybe not in your lifetime.

At least, if you are going stay passively invested as it goes up, then down, hoping you don’t need the money until it goes back up again (I agree. It will go back up someday), know what is happening while you are holding. Here’s what is really going on with your passive index fund:

Price-weighted indexes like the Dow Jones Industrials (DJI) are unscientific but certainly well followed. The DJI is "unscientific" in that the selection of issues that compose it is completely arbitrary. As a result, every time the market begins to falter, it's amazing how new "market leaders" tend to get inserted for older, tired companies which were once the hottest things in the index. Additionally, since it is price weighted, a move by those stocks within the index that have low market capitalization but a high stock price can have an effect on the Dow out of proportion to their true weighting.

If a high-priced stock roars ahead, it adds a huge amount to the DJI increase for the day. If a low-priced stock roars ahead, though, no matter how massive its market capitalization, it's a ho-hummer for the Dow that day. But the DJI has been around for well over 100 years and we like to see the squiggles so squiggle on. Just be aware that if you hear the General Electric (GE, Financial) shares in your 401k were up 5%, you need to check to see what IBM (IBM, Financial), Goldman Sachs (GS, Financial) and Boeing (BA, Financial) – the three currently highest-priced stocks  did that day before celebrating the “gain” in your index fund, which could as easily be down for the day.

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Equal-weighted indexes, like Value Line's, are unweighted geometric indexes. Value Line's index, for instance, began on June 30, 1961 and includes the approximately 1,700 companies followed by the Value Line Investment Survey.

Be aware that because the index is equal weighted, if a $10 stock goes from $10 to $12, it has the same effect on the index as if a $100 stock had gone from $100 to $120 meaning that when a $100 stock goes to $102, it's a nonevent as far as the index is concerned, but when a $10 stock goes to $12, it's a big deal. You'd certainly feel the same if it were your own portfolio so this makes sense as opposed to the way the Dow is computed.

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The most popular indexes for passive investing, capitalization-weighted indexes like the S&P 500, take into account not just price but price times the number of shares outstanding. The S&P is an index composed of the 500 largest corporations in the U.S. by market capitalization. It was begun in its present style in 1923, but the base period used now is 1941-1943, averaging the index at that time to a base of 10. When the S&P was at 1,400 in 2000, that tells you that the value of the 500 biggest companies in America had increased 140 times in value in the 57 years from 1943 to 2000.

Using the same base, the S&P 500’s close Friday at 2,351 shows that these 500 stocks (well, maybe not the same 500 stocks – more on that below) had now risen 235 times in 74 years, a fine showing albeit a bit below par in the more recent years from 2000 to 2017.

Since this index is cap-weighted, more than half the value of the S&P 500 comes from its 50 biggest companies. If you bought $100,000 worth of an S&P 500 index mutual fund in , say, 1998, nearly $3,000 would have gone to buy shares in General Electric, the largest stock in terms of market capitalization while just $10 would have been placed in Shoney's restaurants, No. 500 on the list.

If you had placed $100,000 with a passive S&P 500 index fund on Feb. 17, $3,572 of it would have been invested in Apple (AAPL) as the biggest in market cap and $73 would have gone to News Corp. (NWS), No. 500 on the S&P 500.

In fact, just under $20,000 of your $100,000 would be invested in the 11 stocks below:

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There are some great names here, all of which I believe in the “long run” will amply reward investors. But as someone with a fiduciary duty to my clients, I have to think about the “what-ifs” every day. And, frankly, if there is a correction anytime soon I don’t want to own Facebook (FB, Financial), Apple, Amazon (AMZN, Financial) and others that have already had such nice runs this past couple years.

Indexing "the market" when the index is capitalization-weighted means putting most of your money in a relative handful of stocks.

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Even though most investors’ money flows into the DJI and S&P index funds ($8 trillion at last count for the S&P) there are a couple other index funds I should touch on for those readers.

The New York Stock Exchange (NYSE) Index is a capitalization-weighted index that includes all common stocks listed on the NYSE. This effectively creates a benchmark of the market value (price per share times total shares) of the NYSE. The NYSE Index was started the last day of 1965 with an arbitrary "value" of 50. So, at 500, the NYSE Index would have gone up 10 times since Dec. 31, 1965. This is a fairly broad representation of American industry, with the various issues in the Index comprising nearly two-thirds of the value of all public companies.

The Wilshire Index is a capitalization-weighted index of the 5,000 biggest companies in the U.S. These 5,000 companies represent more than 95% of the market value of all 40,000 companies trading in America today. They are at the core of any investing strategy. If you can't find fine companies from within this universe, you just aren’t looking.

It is a better gauge of "the market" than the DJI or other narrower gauges of value but is used mostly by institutional rather than retail clients, who grew up with "the Dow" and the S&P and stick with them as benchmarks of value.

When we talk about market capitalization, by the way – the value of a single share of a company’s stock times the total number of shares outstanding – delineating what “cap” a company’s stock represents is both a moving target and subject to opinion. Different indexes use different cutoff points, but as a rough frame of reference small-cap stocks are usually thought of as those with market caps of $300 million to as much as $2 billion.

Mid-cap stocks are most often considered those with a market cap of $2 billion to $10 billion. Anything above that is considered large-cap although, these days, with company’s valuations so high, Morningstar and many others have added a giant-cap or mega-cap to their analysis. These are typically companies with a market cap of $100 billion or more. Market cap, like beauty, is often in the eye of the beholder.

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When reviewing any index, remember that all indexes change over time as the U.S. changes. We often think the powerhouses of our generation are invincible but in a nation where individual initiative flourishes and people invent whole new industries in less than a decade, progress comes fast and from unexpected directions. Think Amazon or Microsoft (MSFT) are invincible? Or Facebook, Apple or Intel (INTC)?

Even one of my favorite industries for the next 10 to 20 years, oil and gas, will one day be supplanted by advances in photovoltaics. (Don't despair for those poor displaced Middle Eastern despots just yet if there's one thing they have more of than oil over there, it's broiling sunshine.)

Of the 100 biggest companies in the U.S. 100 years ago, in 1917, only 15 survive as members of the top 100 today. The others were either absorbed by other companies, went bankrupt or, in many cases, are still thriving, though not as members of the S&P 500.

I combed through the most recent changes to the S&P 500 index over the last 16 months. Below are the results. I’ve listed them alphabetically with those companies represented in red having been deleted from the index and those in green having been added:

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You’ll note there are more additions than deletions. That’s because I didn’t include companies that were acquired by another firm. Again, all these changes occurred over just the past 16 months. And no matter what rolling period you select, you will find similar active investment decision-making on this allegedly passive index!

Full Disclosure: At least S&P and I agree on one of these changes. Some clients and I have long owned Alcoa (AA, Financial). When they spun off Arconic (ARNC, Financial), the higher-growth part of the company at the end of October, I not only traded all our Alcoa holdings but added a boatload more of Arconic the week of the spinoff and as it dipped the following couple weeks. Since it is now up just over 50% I no longer recommend it for purchase and have, in fact, placed a tight 5% trailing stop on it.

Please understand I am not trying to discourage anyone from purchasing a passive index fund – I just think you should know what you are getting into before you do.

In fact, while I am very much an active investor and manager, I use certain asset classes as passive investments. For instance, as a counterweight to some of our more aggressive stocks, I own smart beta funds and what I call “unfixed income” funds that give us a capital gain kicker as well as income.

The least of these, so far, is a boring merger and arbitrage mutual fund (Vivaldi Merger Arbitrage). It has done nothing, zilch, bupkus for months. But I know that in a market decline, as long as their positions are intact, it should be rock steady. In a severe market decline companies that have borrowed at 2% and are flush with cash will be seeking more acquisitions, not less, so it may rise quite nicely. So I keep it.

Another category of quasi-passive is our portfolio of preferred shares like NextEra Energy 5% (NEE). As long as they have a combination of low price and great rate making it likely it will be called early I will own them. If we buy a $25 preferred for $22, we are getting increased yield and the possibility of a capital gain. Many of ours have already been called. The ones still in our various portfolios we consider “passive” even though they were actively selected based upon price and quality.

We also own some floating rate mutual funds and ETFs, like Federated Floating Rate and T Rowe Price Floating Rate. Our president may have built a business empire on debt and prefer low rates, but low rates are not kind to “savers” as opposed to risk-takers. The Fed has made it clear that the runway lights are on for a raise and I imagine it won’t be the last this year. These, too, we consider passive investments. Set ‘em and forget ’em until rates are well above the current.

When it comes to what is currently our greatest market exposure -- the long REITs and US and foreign stock portions of our portfolios -- I decide which companies deserve our investment dollars, not some committee whose charter insists they stay “reflective” of the markets.FYI, I’ve made more money over the years buying those firms that are unpopular for whatever reason than chasing those that already constitute the biggest part of the S&P 500.

Of our long portfolio selections, some are components of an index, some are not. I try to buy the shares of companies I believe have the best combination of balance sheet, management, and value as represented by share price and the valuation ratios we use. For instance Cerner Corp. (CERN) is in the index, Franco Nevada (FNV) is not. Yet I view both as equally attractive, with the long-term edge going to non-index component Franco Nevada.

Disclosure: I own Arconic, Cerner, Franco Nevada.

Disclaimer: I encourage you to do your own due diligence on issues I discuss to see if they might be of value in your own investing. Past performance is no guarantee of future results. Even our 18-year track record of success does not guarantee continued success. Good luck or other factors could have played a role. You are welcome to contact me at [email protected] with any questions.

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