Indexing Is NOT Buy And Hold Investing

|
Includes: IWB, IWC, IWM, IWO, IWV, SPY
by: Kurtis Hemmerling

Summary

Buying and holding an index ETF is not buy and hold investing.

Indexing has inclusion rules and stocks failing to meet these criteria are removed.

Indexes are typically cap-weighted.

Inclusion rules and cap-weighting make it difficult to mimic true buy and hold investing.

Whoa! Wait just a second. I thought index investing was buy and hold. I mean, a passive index typically has very low turnover and if you buy and hold an ETF which mirrors that index – particularly if it is cap-weighted – isn’t this the same as buy and hold investing? Not necessarily and this is why.

True Buy and Hold Versus Indexing

To illustrate the difference between true buy and holding investing versus investing in an index fund such as the S&P 500 SPDR (SPY), I will use two examples of buy and hold investors.

High-Growth Harry – Harry is a 25 years old rodeo clown and wants to invest in high-growth small-cap stocks. His goal is to hold them over the next 35 years to draw income from a portfolio of big dividend paying blue chip companies. What specific index ETF would be good at replicating this? Would iShares Russell 2000 Growth ETF (IWO) do the trick? Not even close. That ETF had 28% turnover in the last year – hardly a buy and hold strategy. And it only keeps companies which are currently small and experiencing above average growth – this ETF will cull maturing blue-chip stocks.

Deep-Value Derek – Derek is a 40 year old tuna mascot for the local curling club who buys beaten up stocks with deep value where the dividend was recently cut, frozen or reduced. His experience forecasts that many of these stocks will improve during the next economic cycle to produce a fair-valued portfolio (no longer value) of dividends payers. Which index ETF would mimic his buy and hold methodology?

The problem with index investing is that you are buying stocks with a certain static property – size, style, sector or some other factor. You can’t have a smallcap value ETF turn into a large-cap growth ETF because then it no longer tracks the smallcap value index.

What About Total Market ETFs?

What about total market ETFs that track a very broad index where you own stocks from cradle to grave? There are still problems with this scenario.

An investor does not have the ability to focus his portfolio. How does High-Growth Harry get his initial basket of high-growth smallcaps – and only high-growth smallcaps? He has to own everything in the market in order to get his exposure to smallcap growth. He doesn’t want that. Index ETFs are typically cap-weighted…and thankfully so if you are investing in the total market. I can’t imagine having a fund where BioPharmX Corp (BPMX) has the same weighting as Apple (AAPL). Loading a billion dollars into a company which is worth less than $25 million would be impossible. But with a cap-weighted total market ETF, the smallcap stocks you want to focus on have such little weighting that it is almost irrelevant. You are buying into a large-cap strategy despite owning the entire market.

The total market ETF is not suitable for this buy and hold investor.

A Glance at 10-Year Rolling Buy and Hold Tests

Before we can examine a few buy and hold strategies, we need to settle on how many stocks we will initially buy to lower our idiosyncratic (stock specific) risk. I don’t believe there is any one definitive number – some will say 20 or 30 stocks while other resources say you need more than 100 stocks.

I am going to use 50 stocks. While I realize this might be high for a new investor – I also want to remove as much stock-specific risk from our test. I will choose stocks that are initially found in the Russell 2000 index, although they can migrate anywhere they choose from there. I will only replace a holding if a company delists.

The test will start in January 1999 and will simulate buying and holding for 10 years. I will repeat this every month - hence the term 'rolling test'.

This first buy and hold portfolio will buy 50 stocks which have the highest ‘quality ranking’. This includes such items as margins, asset turnover, return on capital and liquidity ratios. This will be followed by other themes such as growth, value and value with improving analyst sentiment.

Equal-Weight Quality Buy and Hold Portfolio Rolling 10-Year Test

Quality Buy and Hold Test

Equal-Weight Growth Buy and Hold Portfolio Rolling 10-Year Test

10 Year Rolling High Growth Smallcaps

Equal-Weight Value Buy and Hold Portfolio Rolling 10-Year Test

50 Stock Value Vs. IWM ETF

Equal-Weight Value-Sentiment Buy and Hold Portfolio Rolling 10-Year Test

Value Sentiment Rolling 10 Year Performance Portfolio Test

The top part of the chart (gray area) is the rolling 10 year excess return of our buy and hold portfolio versus the Russell 2000 ETF (IWM). The bottom part shows our 10 year rolling returns in red and the benchmark ETF in blue.

Summary

The point of this article was not to suggest which investment style you choose for buy and hold investing. The above tests are just a sample to highlight how various buy and hold strategies have performed over a 10 year window versus the small-cap index. I have no idea what the consequences would be if these portfolios were held for 20, 30 or 50 years. Would the initial portfolio formation factor-tilt matter after 25 years or would all the portfolio performance numbers begin to converge? I cannot say.

But what I can say is that true buy and hold investing is not the same as index investing. An index defines a certain sub-set of stocks. It will not allow you to buy a focused group of companies and watch them evolve and mature over time. Neither a smallcap ETF nor a total market ETF allows for this. And how could it? Do you know of any index which previously tracked smallcap growth but is now mid-cap quality and will eventually be large-cap value?

While indexing does have its place in the investment community and it achieves certain goals – it definitely does not replace true buy and hold investing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.