As a kid, we probably all heard a parent or adult say to us, “now leave it alone, don’t mess with it, and it will heal quicker”. Maybe it was over a scraped knee or small cut, or a blemish on the face. Did you heed their advice? I didn’t. That scab on the knee felt like a bumpy rock stuck to my skin. The blemish was like the tiniest ball bearing, stuck under my skin. Couldn’t just leave it alone. Maybe you can relate, or perhaps I was just an oddity.
I bring this memory of childhood up because it is an example of human behavior in the smallest form that we exhibit in other areas as well. And this behavior is why indices and index funds have impressive price return histories.
Indices are a benchmark, or measuring stick of sorts, for investors to see how markets are doing, have a way to compare and contrast investments like mutual funds, ETFs, and single manager portfolios. Indices are constructed by committees (now anyhow) at large companies who then license various rights out to use their creation as a benchmark or to create another product like an ETF. Some indices are ubiquitous and are known off the tip of investor’s tongues: S&P 500, Nasdaq 100, Dow Jones Industrial Average are three indices that nearly every investor has heard of because of the internet, TV, radio, newspaper, and other mainstream media outlets. They are so popular and ubiquitous that index funds and index ETFs have been created so one can invest just like the index. At first blush (in the 1970’s), the idea of an index fund sounded dumb. But the idea took hold slowly for a variety of reasons and fifty years or so later, index funds represent a very large portion of the investing landscape.
It turns out an index can be quite challenging to outperform, and it isn’t because of the selection prowess of the committee deciding the holdings. No, in fact, an index like the S&P 500 has very general criteria to be selected. A minimum level of market capitalization to meet the large criteria, a certain number of quarters with positive quarters, and a laundry list of types of securities listed on the exchange that are excluded (preferred stock, listed bonds, closed end funds, MLPs, BDOs, ETFs). Simple as it is, it is codified, and a set of rules the committee is bound to follow when making additions. When they make additions and why is not as clear, but since the index business is highly competitive, I suspect ensuring the relevance of the index is an imperative. As an example, every year 6-10 names are added to the S&P 500 and thus 6-10 names are removed. There are no written rules for removal that I have found, but the pattern seems to point to companies in a longer term downturn and companies having experienced some major change due to merger or acquisition. Of the 504 stocks in the S&P 500, only swapping out 6-10 a year is a very small turnover. And we have hit upon two pieces of the secret sauce. Rules are in place (a discipline) for the committee to follow, and change is infrequent. Lastly, the number of companies (504) provide enough dispersion it is unlikely any one company is going to sink the results of the index. Since the index is representative of a group, large capitalization companies in the case of the S&P 500, chances are if one company loses leadership in the index, the money simply flows to another company in the index—and the index keeps chugging along.
Few people have a portfolio where one index is appropriate as the measuring device. If one has a mix of domestic and foreign stocks plus some fixed income, then the proper measuring device should be a mix of at least three indices. People have risk tolerances and timeframes and an index does not. Mainstream media will always want to compare everything to two or three indices, but this does not make it appropriate for investors. Yet another disservice our fine media does for the viewing public!
What are some of the takeaways we can use and benefit from when thinking about indices?
· Indices are vital measuring tools for the investment industry.
· Have a process.An index is created by people on a committee following rules that do not change.
· Keep turnover lower, limit change to the process. As a percentage of the index, the additions and subtractions are small.
· Diversify to reduce risk. The number of companies represented are usually high which lowers the risk level in terms of standard deviation substantially from the typical single stock standard deviation ranging from 35-40, to an index of 500 companies at 19–almost half as much risk.
· Stay consistent. An index doesn’t change its’ stripes in the midst of a crisis or recession, it is steadfast to its’ rules and what it represents.
Is there a better way to invest? Some suggest strongly, “yes”. By recognizing the strengths of the index process and being more purposeful in what is selected, one might be able to develop a better investment process. But we will save that for the next post!
Jason W Rasp
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