Published On: August 3, 2017

Written by: Ben Atwater and Matt Malick

They have an interesting relationship with their son . . .It was interesting how the administration released their tax plan . . . The stock market has been really interesting this year . . . Interestingly, all of these sentences lack meaning.

“Interesting” has become an overused word in the American vernacular – a filler word, a way of saying something while saying nothing, a nonspecific adjective.

In the world of investing, “indexing” is the overused word of the moment.  Everyone seems to be indexing, and much like “interesting,” the word has become ambiguous and nonspecific.

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 cap-weighted index.

With the strong performance of U.S. large-cap companies in the past few years, it’s easy to see why the S&P 500 (and indexing in general) has become so popular.  Between April 2014 and April 2017, passive funds collected $1.57 trillion while active funds forfeited $514 billion.

“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 overvalued.

As of last year, 1,222 mutual funds held ETFs.  Not only do managers choose ETFs to put in mutual funds, but 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 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 decisions as when they were choosing “active 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 increasing funds to international markets (we watched it happen).

But, low and behold, from 2008 until now, the S&P 500 has outpaced international markets 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.

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).

We have real concerns about the valuation of the S&P 500.  With the Cyclically Adjusted Price to Earnings ratio (CAPE, also known as the “Shiller P/E”) now above 30, if history is any guide, it’s a near guarantee that forward ten-year returns for the S&P 500 will be well below average.  It should be no surprise then that people are piling into this index.  As Warren Buffett has said, “What the wise do in the beginning, fools do in the end.”

According to calculations from Bespoke Investment Group, we are in the midst of the second longest bull market in S&P 500 history at 3,063 days – right between the longest ever (4,494 days) and the third longest (2,607 days).  We are in the 11thlongest streak without a 10% correction, the 7th longest streak without a 5% fall and the 4th longest streak without a 3% pullback.

In the meantime, tech leads the advance.  Amazon and Facebook are now $500 billion companies and the five largest American companies, by far, are Apple, Google, Microsoft, Facebook and Amazon.  Interestingly enough, Jeff Bezos, the Amazon founder, briefly became the richest man in the world last week.

One reason to be concerned is that all of this seems too easy right now.  Sure, the S&P chasers will look smart for a time, but when we get to 2027 and 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 positions, rather than buying (through an index) the most popular stocks.


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