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By Peter Pearce

This article is part of a series exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling. For an introduction to the series and the book, see our previous article looking at the return drivers for stocks.

Myth #4 of the book takes aim at the myth that a “Passive” investment style beats an “Active” one. If you’ve read a personal finance blog or article in the last decade, you’ll definitely have heard this myth repeated. A passive investing strategy is one where the investor purchases “representative” broad-market indexes to match as closely as possible the return of the overall stock market. One of the reasons index investing has become so popular is because it is cost efficient and simple. Index funds simply track and invest in whatever companies are in the index, so there’s no need to do any real investigation into the best stocks or sectors.

Indexes are an attractive solution to the investment needs of the majority of individual investors because only the largest accounts are able to diversify across the hundreds of stocks necessary to offer true index-like diversification. However there are a number of problems with using “representative” indexes. Most fundamentally, they are not designed to allocate to stocks that have characteristics that indicate an ability to produce higher returns. For example, the S&P (NYSEARCA:SPY) itself states,Additions to and deletions from an S&P equity index do not in any way reflect an opinion on the investment merits of the companies concerned.” Second, some have unusual biases because of the way they are constructed, which I will demonstrate later in this article. Dever captures the irrationality of investing in “representative” indexes quite well with, “Why would a person subrogate their investment process to an index rather than manage their portfolio themselves pursuant to some clearly defined, objective, profit motivated, systematic and repeatable set of rules?”

The major index providers began offering indexes with the goal of systematically maximizing returns by following a clearly-defined set of rules as an alternative to the “representative” index funds. We can think of these as Equal-Weighted and Fundamental index funds. We’ll divide our discussion into two of the most popular indexes, examining their drawbacks and alternatives.

Dow Jones Industrial Average

A Price-Weighted index is a stock index where each stock’s influence in the index is determined solely by its price per share. It’s one of the simplest types of index composition to wrap your head around. The prices of each stock in the index are added together and then the total divided by the total number of stocks. Stocks with a higher price are given more weight and will therefore have a greater influence on the performance of the index.

To get a better idea of how a price weighted index is calculated, consider this example. Imagine two companies A and B, which are identical in every way and have shares priced at $100. There is a price-weighted index based only on these 2 stocks, and since both stocks have the same price, each company would account for 50% of the weight of the index. Now imagine stock B undergoes a 10 to 1 stock split because management wants to make the stock price more attractive to small investors, and is now priced at $10. Stock A would now account for 91% of the value of the index while stock B accounts for only 9%. A 10% change in the price of stock A would change the value of the index by 9.1% while a 10% change in the price of stock B would only change the value of the index by 0.9%.

Since both companies are exactly identical, there is no rational investment strategy that could justify allocating more to one stock than the other yet this is exactly the method price-weighted indexes take in allocating your funds.

The Dow Jones Industrial Average (DJIA) is the most well known price-weighted index and a popular choice for many investors through the SPDR Dow Jones Industrial Average (DIA). The DJIA was originally created in the late nineteenth century when keeping the calculations simple was essential to updating the index regularly. Keeping computational mechanics simple is no longer an issue and subrogating the investment decision process to this arcane method is clearly inappropriate.

An Equal-Weighted index would be a more appropriate way to gain exposure. The stocks in these indexes are weighted equally so that a 1% move in any stock in the index has the same impact on the index as a 1% move in any of the other stocks.

There is not yet an Equal-Weighted DJIA index fund, but consider the Rydex S&P 500 Equal Weight ETF (RSP) that includes the same stocks that comprise the S&P 500 but weights them equally. When compared with “capitalization-weighted” indexes such as the S&P500, discussed below, equally-weighted indexes allocate less to large companies and more to smaller companies, which can have an ambiguous effect. They offer both: greater exposure to undervalued stocks, as the bottom deciles of the S&P 500 tends to outperform the top deciles, but also would result in faltering performance when large companies lead the market, such as the last half of the 1990s.

(Click charts to expand)

The second problem with the DJIA is its components are chosen more or less arbitrarily by the Dow Jones & Co to represent different industries, they are not chosen according to fixed or well-defined rules. Stocks are only added to the index if, in the words of Dow Jones Indexes, “the company has an excellent reputation, demonstrates sustained growth, is of interest to a large number of people and accurately represents the market sectors covered by the averages.” The analysts selecting stocks for inclusion in the index are not selecting those that they feel have the greatest appreciation potential!

Standard & Poor’s 500 Index

The S&P 500 is by far the most well known index in the world and has become the benchmark against which many stock portfolios are measured. It’s a capitalization-weighted index, which is one where funds are allocated relative to the size of the company, so that the largest companies have the largest impact on the index value.

The S&P500 has certain characteristics that a stock must possess to be added to the index, for example: market capitalization above $4 billion, public float above 50%, and at least 250,000 shares traded in each of the six months prior, among other conditions. Once a stock has been included in the index, it may violate the conditions and not be deleted from the index if S&P decides the violation to be temporary. Over the last decade, the composition of the index has changed to the tune of 6.1% portfolio turnover. Just over 300 stocks were deleted from the index in order to keep the composition in line with the rules above. So ultimately the composition of the S&P 500 is not passive, it’s a subjective compilation of 500 stocks that might or might not fully adhere to the conditions outlined. This brings up the same question that we asked about the Dow Jones: Why bias the weighting of your portfolio to a characteristic, in this case company size, which does not point to an ability to achieve higher returns?

Compare the allocation of the S&P500 to another index for example. The PowerShares FTSE RAFI US 1000 Index (PRF), which consists of 1,000 U.S listed companies and is weighted to those with the largest fundamental values. Weighting factors include dividends, book value, sales and cash flow. Instead of simply “representing” the U.S large cap market, the index systematically tries to reduce exposure to overvalued stocks. Fundamental index strategies add value by dynamically tilting the allocation against overbought stocks, essentially betting against momentum. When value stocks are out of favor, they increase their allocation to them, and when value is in favor, the index tilts less weight towards these stocks because of their higher price. This type of index rebalances out of popular stocks and into unpopular ones.

As a final note, consider the Guggenheim Insider ETF (NFO) as another alternative to typical “representative” indexes. The Insider index tracks the performance of the Sabrient Insider Sentiment Index, which consists of 100 stocks that are selected to be purchased based on insider trading trends and increases in analysts’ earnings estimates. The thinking here is that corporate insiders know more about its prospects, so increased purchasing by these “insiders” serves as a positive signal for a stock price. The returns of the Guggenheim Insider ETF are a result of a selection process that creates an index composed of stocks based on characteristics that are statistically likely to result in market outperformance.

The goal is to identify a subset of stocks from within a traditional broad-based index that exhibit characteristics that indicate the greatest appreciation potential. This type of approach provides the potential to generate higher long-term returns compared with market-cap-weighted indexes. Other fundamental indexes might have the goal of risk containment such as the Guggenheim Defensive Equity ETF (DEF).

Fundamentally-based ETFs have been available since 2005, and there are many other examples. These ETFs have principally focused on those selecting companies on the U.S. indexes for investment. Myth #16 in the book addressed how familiarity bias often keeps investors from diversifying their portfolio and exposes them to unnecessary risks. Though none of the ETFs mentioned here allows short-selling as a strategic return driver, our article on myth #10 explicitly shows how short-selling gives small investors the edge over some large institutional players.

Additional Disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.

Source: Your ETF Choices Can Do Better Than The Indexes