Rethinking Index Investing

There are two general different ways to play the equities game. You can try to pick individual stocks yourself in the hopes of someday replicating the success of Warren Buffett, or you can leave such aspirations to the more ambitious folks in our society and simply try to earn an average return.

As I have argued before, although I do believe it is possible to beat the market consistently as Warren Buffett has done, this does not mean that just anyone can hope to do so.

It takes a unique person. Of course, where does that leave the rest of us?
Mr. Buffett has said that the ordinary investor is better off investing in a passively managed index fund than an actively managed mutual fund. While the proponents and salesmen of index funds or fund families that try to capture the benefits of index funds love to use this quotation for their own self-serving benefit, it is hard to disagree with Mr. Buffett. He calls such ordinary investors “know-nothing investors,” although he doesn’t mean it as an insult. He just means that if you don't know what you are doing, it is safest to simply accept your mediocrity and guarantee yourself average returns. This begs the question, though, what is “average? “

This argument is also consistent with the efficient market theorist’s investment strategy. Since we can't expect to beat the market anyway, why not simply arrange to earn the relatively high returns equities offer us while minimizing fees through passive management? Note the underlying assumption behind all of this, that "the market" is best proxied by a value-weighted index, and this is where we get in to trouble.

What is “the market?” Professor Richard Roll’s famous critique of the Capital Asset Pricing Model has stumped theorists for nearly thirty years now. He contended that we will never be able to truly quantify risk because the true “market” portfolio is unobservable – it includes all assets that contribute to wealth, everything from stocks to baseball cards to human capital.

So let me ask two simple questions. Why are market-value weighted indexes such as the Nasdaq Composite or S&P 500 the most generally accepted benchmarks by which to compare investment results? Is there any particular reason for such value-weighting other than convention?

Some fund companies have made a big business out of creating alternative indexes that try to outperform or by taking the components of existing indexes and weighting them equally, and yet others weight them according to the Fama-French Three Factor Model. Yet we continue to measure performance relative to value-weighted benchmarks. Perhaps, since as individual investors we likely never have sufficient wealth to affect the value of one stock purely through our individual trades, we should have no limit to how to we (passively) allocate our wealth. Hence, by benchmarking ourselves to the S&P 500 we are actually overstating our relative performance.

Exchange traded funds, ETFs, are very much in vogue at the moment. The original ETFs were broad-market index funds such as the SPDRs, which mimic the performance of the S&P 500, and appealed to two types of investors. The first type is the delusional folks that think they can actually predict the direction of the market. We can thank those geniuses, I suppose, for providing liquidity to the second type of investor who uses the SPDRs for true investment purposes.

But by purchasing shares of SPDRs or any other broad-market index fund, investors are inadvertently investing most heavily in those companies that are most likely to be overvalued. This is the crux of my argument. Since the S&P 500 (SPY) is a value-weighted index, the value of one share of a SPDR will be dominated by the largest companies and those that have most recently appreciated. So while you may rest assured that your share does in fact represent the collective performance of five hundred different companies, why should you prefer that, among those five hundred companies, you are weighted towards the ones that are quite possibly the most overvalued?

For illustration, consider the three largest components of the S&P 500; ExxonMobil (XOM), GE (GE) and Microsoft (MSFT). This trio is clearly not surprising - these companies are the three biggest in the economy. But what makes me think that these three companies deserve the largest portion of my money? Do I really want $5.88 of the $146.00 I pay for my SPDR to be allocated to ExxonMobil? Moreover, the mere fact ExxonMobil is so large (as measured by market value) may be because investors are paying too much for it.

These are philosophical questions. The index fund advocate will argue that investing in the largest companies is the point. That is, because ExxonMobil is so dominant in the economy, so too should it be dominate in my index fund. But to me this seems unnecessarily limiting, since both larger companies and those that have recently appreciated are likely to underperform their counterparts - provided we believe the evidence provided by Fama and French (1988, 1992) of long-term mean reversion in stock prices and the outperformance of small firms. (I do.)

As I have a habit of doing, I have raised some questions without suggesting any real answers. I will leave that up to anyone wishing to comment.