How Stock Market Indices Underperform

One frequent complaint made about stock-market indices is that they’re not truly representative of the stock market as a whole, since they exhibit what’s known as “survivorship bias”. If a company is failing it drops out of the index, to be replaced by a more successful firm. In turn, that should boost the index’s return, right?

Wrong. It’s wrong for the S&P 500, and, says Henry Blodget, quoting John Mauldin, it’s wrong for the Dow, too:

If Dow Jones hadn’t tinkered with the index, the 30 companies would have merged or failed their way down to just 9 survivors. Of the 21 companies in the original 30 that are now gone, 20 disappeared through M&A, some were replaced by successor firms and others not, and only one (Bethlehem Steel) failed outright.

But this no-fiddling index would have topped out at just over 30,000 in October 2007 and would have finished 2008 at 14,600…

With the Dow 30, your $100 would have grown to $96,993 as of December 2008, but the Original 30 would have grown to $161,603…

[T]here is an even bigger differential if you simply equal-weight the components rather than use a price-weighting methodology. Your $100 grows at a 10.4% clip and becomes $272,554, or almost three times the actual Dow 30.

Maybe this is the best possible reason for not investing in index funds: indexes underperform. Instead, just pick a basket of stocks, and hold them forever, reinvesting dividends. Some will go to zero. But you’ll still be significantly better off than holding the index, assuming you can reinvest dividends cost-free.

Comments

[Hedged In:]

The Dow is unrepresentative of indexing in general, because it's so narrow (only 30 stocks), and due to the annual changes is more like an actively managed fund.

If you use a total market index from Vanguard (VXF), iShares (IYY) or StateStreet (TMW), you avoid those problems.

Apr 06 12:06 PM

[pacman1947:]

Felix,
Your observations indicate that buy and hold works quite well over very long periods of time, that active management and the associated fees rarely pays off, and that the averages are manifestations of some group of unknown persons who change them periodically.

Now I'm not saying all this is true, but the data supports this perception for the DJIA and S&P500.

Good article, Felix!

Apr 06 12:33 PM

[Lee Eugene ...:]

I agree for the buy and hope crowd. Unless you are willing to put in the time to trade and can do it well (two big if's), a basket of quality will beat an index. People seem to forget that an the Dow and S+P are run by public firms and actual humans decide who gets in. This is inherently flawed and in the end you are simply investing in S+P's top 500 stocks. However, I do agree with Hedged In that something like VT (the Vangaurd Total World Index that has everything) is a better way to play passive. Keep in mind, though, Vanguard does use sampling to mimic the index. It hasn't been a problem yet. . .

Apr 06 03:46 PM

[Trent Hauck:]

I wonder why anyone would use indexes in the first place - specifically narrow ones like the Dow. They are often behind the curve when it comes to the best stocks.

The only thing they have been good for as of late is to move public sentiment to irrational optimism or pessimism. Of course, only until close the next day.

Apr 06 05:08 PM

[William Cowie:]

The overall conconclusion is interesting and worth keeping in mind. It is why I eschew index funds and try to figure things out myself.

The underperformance of a broad index like the S&P 500 is less severe and, for someone who wants to invest in stocks, but is intimidated for whatever reason, it is still a better way to go than most mutual funds (their only other alternative).

Apr 06 05:10 PM

[ANTS:]

So, why is it that active management cant outperform the "underperforming" index. More to think about.

Apr 06 06:13 PM

[jimhsu:]

Or perhaps one could specifically purchase companies that have been delisted for x months? I remember CXO advisory ran an article on that sometime, but I can't find it.

Apr 06 08:35 PM

[Trent Hauck:]

ANTS: I think it has something to poor management.

Apr 06 10:28 PM

[DR. ALPHA:]

I'm glad that you open up this line of reasoning. Here is a related concern that I have long held, but have not done any testing on to verify:

Stocks that enter and exit the index can be formulaically predicted before announcements of index reshuffling are made. Furthermore, there is a lag between these announcements and the moment index trackers place trades to match the new lineup. The market can trade in advance of the index trackers, anticipating the large movement of shares. This creates a poor price point for the index trackers when the trades to match the index finally take place.

Since this problem is systematic and recurring, it should lead to persistent underperformance.

Apr 06 11:07 PM

[Moon Kil Woong:]

If you like paying trading fees, taxes on theoretical gains, and management fees go right ahead on keep paying to buy ETFs and mutual funds. If you can't afford to buy stock and diversify you probably shouldn't be playing.

Of course, no one likes to hear they shouldn't play/gamble. And no one likes to hear that the fish should be kept away from the poker table to keep them from losing it all. But it is the honest truth.

As for churning to keep a basket of stocks that underperforms, go figure. That seems to be no different than mutual funds except they magically outperform 85% of them. As many a writer points out over and over, this is probably be because of management fees and the fact most mutual fund managers actually get paid to closely mirror the index they are pegged to.

Which leads to the last question, why mutual funds if they are just tagging to indexes anyway. Where's the management and where's the performance?

Your better off buying through Scottrade or E-Trade as long as you don't get ripped off by them executing your trade to reap excessive spreads. I guess everyone's gotta have a scam to make money, ehh. To know how people take advantage of you is cruel but it's still better than not knowing.

Apr 06 11:55 PM

[Harry Tuttle:]

Most portfolio managers do worse than the S&P which makes the index a better investment unless you can find the rare manager who beats the S&P on a risk-adjusted basis.

In other words, the original S&P may beat the S&P but the latter beats most mutual funds. On a risk adjusted unlevered basis it beats most hedge funds as well.

What really counts is marketing.

Apr 07 09:43 AM