Published On: October 6, 2021
Written by: Ben Atwater and Matt Malick
In the world of investing, “indexing” is an overused, ambiguous and nonspecific word.
Investopedia defines indexing as “the adjustment of the weights of assets in an investment portfolio so that its performance matches that of an index.” Indexing the Standard and Poor’s 500 stock index has become especially prevalent. In fact, both the largest mutual fund (Vanguard 500 Index, VFIAX), and the largest exchange-traded fund (SPDR, SPY), track the holdings, weightings and performance of the market cap-weighted S&P 500 index.
With the strong performance of U.S. large cap companies since the financial crisis, it is easy to see why the S&P 500 (and “indexing” in general) has become so popular. As of late 2021, VFIAX held more than $920 billion in assets and SPY held over $384 billion in assets.
This sounds easy so far, but “indexing” is complex for three reasons: 1) indexes have become the tools of active managers; 2) choosing what to index is – in and of itself – an active (not a passive) decision; and 3) the mother of all indexes (the S&P 500) is too popular.
Well over 1,000 mutual funds own ETFs. Not only do managers choose ETFs to put in mutual funds, but even more commonly managers and advisors build ETF portfolios for clients. In many cases, these ETF portfolios, whether at a big wire house like Merrill Lynch or at a small RIA firm, have completely or partially replaced what was once a portfolio of best-in-class active managers like Dodge and Cox, Fidelity, PIMCO, Legg Mason, etc.
To build these portfolios, allocators must make the same kinds of active decisions as when they were choosing mutual fund managers, namely which asset classes to use and how to weight them. Therefore, although advisors index the components of the portfolios, the most important decision (asset allocation) is still an active decision, whether a human advisor or a “robo advisor” makes the call.
Despite indexing sounding easy and effective, the reality is much more complex. In 1999, when the S&P was roaring like it is today, were investors rushing to diversify into international markets? Not a chance.
But, subsequently, from 2000 through 2007, international markets beat the S&P by a multiple of more than five. Make no mistake, as this trend persisted, managers allocated more and more funds to international markets (we watched it happen) and away from the S&P 500.
By the mid-2000s, most asset allocation models had an overweight exposure to the BRICs (Brazil, Russia, India, China). Many experts promoted the growth of emerging economies and assumed it would continue unabated. They viewed these countries as entering a stage of newly advanced economic development, based not least on their geographic heft, demographic advantages and “managed” economies.
But low and behold, over the last ten years, the S&P 500 has outpaced the BRIC ETF (BKF) by a factor of 6.5. And, predictably, institutions and individuals have been increasing their exposure to U.S. domestic stocks during this run. In many cases, the tool for adding this exposure is an S&P 500 index fund.
All the while, these investment shops have been decreasing and even eliminating exposure to the once celebrated emerging markets bucket. Popularity can be fleeting. As Warren Buffett has said, “What the wise do in the beginning, fools do in the end.”
In our view, the same dangerous performance-chasing that lures people into any investment is just as pronounced when indexing (if not more so because people perceive indexes as safe), whether that be an emerging market index or an S&P 500 index.
Although the S&P 500 is seemingly quite diversified, its top seven holdings are “technology” stocks – Apple, Microsoft, Amazon, Alphabet, Facebook, Tesla and Nvidia. And because the S&P is market capitalization weighted (the largest companies constitute more of the index) these seven holdings account for more than 25% of the S&P 500. Put differently, about 1.4% of the individual companies in the index make-up more than a quarter of the value of the index.
One cause for concern is that investing just seems too easy right now. The S&P chasers may sound smart, but ten years from now, when we look back, we would bet that indexing the S&P 500 will not live up to its lofty expectations. Now, as much as ever, is the time for equal weighting and dollar-cost-averaging into individual stocks, rather than buying (through an index) the most popular stocks.
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