The index investing sales pitch is pretty straightforward: Markets are so efficient that most investors are best served with a passive approach using index funds. Many investors seem to be buying. Bloomberg News reports that more than $692 billion flowed into index-based mutual funds and exchange-traded-funds (ETFs) last year, while actively-managed funds experienced more than $45 billion in outflows. Bloomberg also notes that with the rise in customized indexes, there are now more indexes than U.S. stocks. It seems that index investing remains quite popular, but I want to explain why it may not be as passive or as low risk as advertised.
First, consider how a typical index is created: An oversight committee, operating with some general guidelines, determines which stocks will constitute the index. Using the S&P 500 Index as an example, the committee considers things like trading volume, the size of the business, profitability and various subjective factors in order to “assure that the index is an accurate picture of the [U.S.] stock market.” The committee makes adjustments over time resulting in a turnover of about 40 stocks per year. This approach may seem reasonable, but sometimes it yields unexpected results. For example, you may be surprised to learn that Facebook and Google parent, Alphabet, will soon be removed from the S&P Dow Jones Technology Index. The committee plans to move them to its new Communications Index. I suspect that if passive investors looked more closely at the indexes they own, they might find similar surprises.
With committees shifting stocks in and out of the indexes, it seems worthwhile to examine the impact of those changes over time. In 2004, Wharton Finance professor Jeremy Siegel and his student Jeremy Schwartz published a study which determined that the returns of the original firms in the S&P 500 Index, without changes, outperformed the continually-adjusted index from the period of inception in 1957 to 2003, and they did so with lower volatility. Siegel and Schwartz attributed most of the difference in performance to the tendency to drop lower priced, value-style shares in favor of higher priced, growth-style shares over time.
Another key element of index construction is how the components are weighted. The most common approach is to weight index components based on stock market value. The greater this value, the greater the weighting in the index. During a prolonged bull market, one result of this approach is that index investors are increasingly invested in high-momentum stocks. That’s good news if you’re seeking a momentum strategy. However, I believe few index buyers would consider themselves momentum investors, and still fewer have considered the risks of momentum investing.
Historically, some of the worst outcomes occurred when investors went along with a popular concept without having a good grasp of the risks involved. With index investing becoming a “no brainer” for so many, it may be a good time for its advocates to re-examine some of its risks and assumptions.