Source: The Reformed Broker
A market index is just a group of securities. With 7000 investable stocks in the US, there are 2 7000 possible combinations. But actually, with different weighting schemes, there are more. This means there are now more indices out there than there are large-cap stocks. With index-based Exchange Traded Funds (ETFs) widely available, index investing has come to resemble particle physics, with quantum creation and destruction, spooky entanglement, and a fund’s success often predicated on its spin, strangeness and charm.
The first index was created by Charles Dow in 1896 as a simple average of stock prices. Index methodology moved towards using market capitalization—the stock price times the number of shares outstanding—as the principal means of weighting equities in an index. Now, there are over 130,000 global indices calculated and tracked by S&P / Dow Jones—from the Philippines Property Index to Philadelphia Oil Services. Many observers have noted that there appears to be a “bubble” in indices.
Indexes help investors evaluate a manager’s skill relative to a benchmark, and give them the opportunity to put their money into a widely diversified portfolio if they choose. Now, what used to be looked at as the value-added of stock picking can be reduced to quantitative factors, and individual managers’ approach can be simulated and back-tested. Even Warren Buffett’s portfolio—with his preference for “wide moats” and consistent cash flow—has been cloned and replicated. So even after he passes away, his methodology can live on.
Source: Frazinni, Kabilla, and Peterson
But cap-weighted indices aren’t really neutral. They have their own biases. The gradual dissemination of new information into the market—and its incorporation into securities prices—means that these indices carry a certain amount of momentum. Also, since the priciest stocks are weighted the most heavily, they also have a growth tilt to their composition. So index investing is really growth-portfolio momentum investing.
In addition, cap-weighting creates its own paradoxes. When a company buys back its shares—everything else being equal—its price goes up while the number of shares goes down. Individual shareholders will profit as their ownership stake in the company increases, while index investors would not—the market cap doesn’t change. The converse holds true for companies that issue new shares, diluting the ownership of their shareholders. Individual shareholders would be hurt; index-holders would not.
Finally, technical issues related to index investing can lead to significant short-term price volatility. The flash crashes of May 2010 and August 2015 caused a lot of turmoil, and the Crash of 1987 was also linked to index-based portfolio activity. While the fundamentals of the market and economy had not changed, it appeared for a while as if the market was anticipating serious problems.
All this is not to suggest that indexes and index-based investing are bad. On the contrary, cap-weighted indices have been helpful for investors and are now central to modern money management. Like most areas of life, however, it’s important not to go too far. “When you find honey,” Proverbs says, “eat just enough. Too much, and you’ll get sick.”
Douglas R. Tengdin, CFA
Chief Investment Officer