This is part 4 of a series of articles examining the idea that index funds are superior investments to a portfolio of individual stocks.
Part 1 of this series I examined the idea that index funds necessarily deliver better performance than individual stocks.
Part 2 examined the idea that index funds are a less expensive way to invest than buying individual stocks.
Part 3 examined the idea that index funds provide the required level of diversification, and that the type of diversification provided by index funds is a good thing.
Before I start the analysis, let me reiterate my stance on index funds – index funds are great. I have a significant portion of my wealth in index funds. I believe index funds are the best investment vehicle for the vast majority of investors. Index funds are an easy “set and forget” investment. They are awesome for new investors or investors who want to regularly invest smallish sums of money. They are an easy way to capture the average return of the market.
Proponents of index funds aren’t content to stop there though. For some reason they feel the need to make additional claims that just aren’t backed up by basic statistics or common sense. I’m writing these articles to refute some of those claims.
Active vs. passive investments
First, some definitions are in order, if for no other reason than to ensure we all mean the same thing by passive management and active management.
By “active management” I mean the management of a portfolio where a person is making 2 types of decisions:
– Which investments to buy
– How much of each investment to buy
So, if a person is deciding whether or not to buy Google for a portfolio, it’s actively managed. And/or, if a person is told to buy Google but has discretion over how much Google to buy, then the portfolio is actively managed.
For most mutual funds the line between passive and actively managed is pretty clear. If it’s not an index fund then it’s almost certainly an actively managed fund. If there’s a fund manager or team of managers who are picking investments then it’s almost certainly an actively managed fund.
Unfortunately, it’s not nearly as easy to determine if a fund is a passively managed fund.
What qualifies as passive?
If an actively managed fund is one where a person is making buy/sell decisions, then it would stand to reason that a passively managed fun is one where a person does NOT make buy/sell decision.
To most people, this would mean that a passively managed investment is one that’s managed through some set of rules that have been established.
For example, a S&P 500 index tracks the largest 500 companies in the US. A S&P 500 index fund is a mutual fund that holds the same stocks in the same proportion as are held in the S&P 500 index fund.
On its face, it would appear that a S&P 500 index fund is a passive investment, right?
Well, let’s do a little thought experiment. Let’s say that I created a new index fund called NewFund. Assets in NewFund will be allocated so half the money is invested to track the S&P 500 index fund, and the other half of the money is invested to track the MSCI index (one of the primary international indexes).
Would NewFund be a passive investment? Well, if NewFund was just tracking either the S&P 500 or the MSCI Index then it would certainly be a passive investment. The fact that it’s now tracking both of them shouldn’t change the fact that it’s a passive investment, right?
Now let’s say that NewFund is changed so that it still invests some of the assets to match the S&P 500 and some assets to match the MSCI Index, but I decide each year what percentage of the assets to allocate to each fund. Maybe the first year I allocated 60%/40% to the S&P 500/MSCI and the next year it’s allocated 30%/70%.
By my definition (and I think most people would agree with me) this is now an actively managed fund, as somebody is deciding how much money to allocate to each of the investments.
The S&P 500 index is not passive
Here’s where the problem occurs.
Somebody has to decide how the S&P 500 index is built. The name tells us what companies are in the index – the 500 largest US companies. But why 500? Why not 250? Why not 600? Picking the 500 largest companies is somewhat arbitrary. That doesn’t mean it’s necessarily wrong, but it is arbitrary.
Instead of having some number of companies, why not have a criteria for inclusion? For example, why not have the index be all companies with a market cap of greater than $10B? Or companies with annual sales of more than $1B? Or any number of other potential criteria?
So for whatever reason the index we all pay attention to (the S&P500 is made up of the 500 biggest publicly traded companies in the US (actually, that’s not even true, it’s made up of 505 companies, but let’s ignore that for now).
Fine.
What’s crazy is the algorithm for deciding how the companies are weighted in the index. Most indices (including the S&P 500) are weighted according to their market capitalization (total number of shares * price/share). That means that a company worth $100B will be weighted 10x more than a company worth $10B.
As of November, 2019, Microsoft has the largest market cap and thus is the most heavily weighted stock in the S&P 500. Microsoft makes up 4.40% of the index. Apple has the next highest market cap and makes up 4.33% of the index. Amazon is 3rd at 2.84%.
If we go all the way to the bottom of the list we see that the number 505 company, News Corporation, makes up .006% of the S&P 500. Number 504 is Macerich Company at .011%.
Again, there’s not necessarily a right or wrong way to weight companies in an index, but let’s compare the cap weighting to an equal weighting.
If the 505 companies in the S&P 500 were equally weighted then each company would be 1/505th of the index, or .198%.
This means that in the S&P 500 Microsoft is weighted 21.87x higher than it would be in an equally weighted index, and the number 505 company, News Corporation, has a weight that’s 1/31.3 (or about 3%) as much as it would be under an equally weighted index.
Microsoft’s weighting in the S&P 500 is 694x higher than News Corporation’s weighting.
To put that in perspective, if both Microsoft and News Corporation had stock prices of $100, if Microsoft’s stock price went up to $101, it would have the same effect on the index as if News Corps stock went to $794.
The reality is that the weighting of the bottom 100 stocks in the S&P 500 are so small that they don’t really matter. The bottom 100 stocks combined add up to about 3.2% of the index. That’s less than either of the top 2 stocks alone. The bottom 250 stocks in the index make up 12.4% of the index, and the bottom 400 stocks make up just 33.5% of the index.
Why even have the bottom 250 stocks in the index? Their weighting is so small they effectively don’t matter.
I’ve never heard of any financial advisor or academic study recommend that investors build their own portfolios this way.
Have you ever seen, heard, or read of anybody advising an investor to have their largest investment be 694x larger than their smallest investment?
I have not. Most advisors recommend a relatively equal weighting. They typically advise you to spread your money relatively equally across 10 or 20 or 30 different investments.
But regardless of whether or not cap weighting is better than equal weighting, the fact is that SOMEBODY HAD TO PICK THE WEIGHTING for the S&P 500 index.
And the fact that somebody is picking the companies in the index (by creating an arbitrary rule to include the largest ~500 companies) and picking the weighting of those companies is pretty much the definition of a non-passive investment, right?
The S&P 500 index rebalances…the wrong way
But here’s the worst thing about the S&P 500 index. Because the index is made up of the ~500 largest companies, there’s bound to be some churn in the index. Some companies struggle (or outright fail) and fall out of the top 500. Smaller companies succeed and grow into the top 500.
According to an article from Business Insider, approximately 22 companies, or 4.4%, are added or removed from the index each year.
4.4% annual turnover is certainly low compared with many actively managed fund, but it’s a lot higher than 0%, which is what you can have when you manage your own portfolio.
The good news is that most of this 4.4% turnover happens on the fringes of the index. That is, the company that was 497th on the list last year falls to 527th on the list this year and is removed from the index. Since, as I said before, the bottom 100 companies on the list make up 3.2% of the index. Buying and selling those stocks every year won’t really generate much in the way of capital gains.
But that 4.4% turnover is just the turnover of the companies in the index each year. There’s also turnover in the weighting of each company in the index.
Remember, the S&P 500 is cap weighted. So if Microsoft’s market cap changes, then its weighting in the index must change.
Think of it this way – let’s say that next year the market cap of Microsoft and the market cap of News Corporation switch. The weights of those companies in the S&P 500 would also need to change. Microsoft would become just .006% of the index and News Corporation would become 4.4%.
There would be no turnover in the S&P 500 (both companies were in the S&P 500 index before and after the change), but there would need to be a significant amount of selling of Microsoft stock and buying of News Corp stock so that the weighting of companies in the index fund would match the index.
So you sell a bunch of Microsoft stock and generate a bunch of capital gains that shareholders will need to pay taxes on.
But here’s the really scary thing – what happens when there’s lots of buying of a stock? The price goes up. What happens when there’s lots of selling of a stock? The price goes down.
If a company’s stock goes up then its market cap goes up (remember, the market cap is just number of shares * price per share). If the market cap goes up then the company’s weighting in the index must go up. If the weighting goes up then S&P 500 index funds must buy more of that stock to match the index. And if lots of index funds start buying the stock then the price goes up. And if the price goes up then the market cap goes up…
It’s a vicious circle where the S&P 500 index sells stocks that decrease in price and buys stocks that increase in price.
That’s exactly the opposite of the “buy low, sell high” advice for successful investing.
Conclusion
Index funds are not true passive investments. Somebody is making (or has made) the decision on what investments to include in the index.
In addition, the fact that the S&P 500 is cap weighted means that the performance of the index is dominated by about 100 companies.
None of this is to imply that the S&P 500 index is bad, but it certainly means that the S&P 500 index (and virtually all other index funds) are a lot less passive (and less tax efficient) than most investors believe.
If you want true diversification and tax efficiency and if you have at least a moderately large portfolio, you’re almost certainly better off creating your own portfolio of 20-30 companies.