Rethinking Index Investing

March 14, 2024  |  Tim Fortier

In the realm of financial markets, portfolio managers are tasked with the crucial responsibility of making sound investment decisions on behalf of their clients.

To aid in this decision-making process, portfolio managers often rely on indexes as benchmarks for evaluating the performance of their portfolios.

Indexes serve as valuable tools for measuring the overall market’s performance and comparing the returns of a portfolio against a specific market segment or investment strategy.

However, benchmarks have become more than that as they have also become the basis of investable products, namely passive index funds.

Based on recent data, passive indexing constitutes a significant portion of investment management:

  • As of 2022, passive funds hold a higher percentage of the U.S. stock market than active funds, with passive ownership surpassing active management.
  • In 2019, passive management controlled 45% of assets in U.S. stock-based funds, a notable increase from around 25% a decade prior.
  • Estimates suggest passive indexing could overtake active management by 2026, with passive funds currently constituting around 54% of the market.

Given the significance of passive indexing to investors, the choice of the underlying index is more than trivial as trillions of dollars are controlled by this decision.

In today’s issue, I take a deep dive into the importance of index selection.

An index fund is a basket of stocks that seeks to mirror the performance of a specific market index.

The most popular index funds track the S&P 500, which includes 500 of the top companies in leading industries of the U.S. economy.

But does this popular benchmark provide the best index for investors to follow?

One of the advantages of following an index approach to investing is that it is very systematic and rules-based. It removes any emotional biases driven by attitudes and feelings from the investment process.

However, it may still be subject to errors due to faulty reasoning or statistical, information processing.

Let me explain.

The selection of the S&P Index is intended to provide investors with exposure to U.S. large-cap stocks, or size factor. The investment universe is the 500 stocks with the largest market capitalization.

A recent research paper written by a colleague of mine, Arun Soni, demonstrates how the universally accepted “truth,” that the S&P 500 index is the best choice for large-size exposure, is flawed.

Figure 1 (above) plots the distribution of market capitalization among the 500 stock universe.

What many investors fail to realize is the extreme left had skew, ie the number of smaller companies whose median market capitalization is $92 billion (red).

On the other hand, there are five stocks with extreme market capitalizations that exceed $1.593 billion (dark blue). Statistically, these could be classified as large outliers that pull the market capitalization mean average to the right.

If you were sitting in a coffee shop in which Jeff Bezos and Bill Gates were also customers, one could correctly say that the average net worth of the coffee shop’s customers was in the hundreds of millions.

Now your net worth may not have changed, but by the selection universe (coffee shop customers), the statement is true.

We have seen in recent years the effect of this “coffee shop” example where a very small handful of stocks have produced all of the gains in the index while the 490 or so stocks have provided negligible return contributions because of the index construction.

Back to our index. The long tail of small market capitalization stocks has a negligible contribution to the large-capitalization exposure that investors intend to seek when investing in the S&P 500 index. Eliminating the tail corrects the information processing error.

It is equally important to recognize that the five stocks whose market capitalization exceeds $1.593 billion are statistically identical relative to the mean, just as the equally weighted mean market capitalization of $92 billion.

Thus truncating their value to $1.630 billion corrects the statistical error caused by the extreme skew caused by their entire inclusion.

Referring back to diagram 1, what we are left with is everything in the light blue.

Everything in the red has been removed and the five extreme outliers on the right-hand side are reduced to equal weight so that no one has more importance over the other.

The results will surprise many.

After making the above adjustments, the resulting 50 stocks have an equally weighted mean market capitalization of $520 billion and a greatly corrected skew that is more symmetrical.

More importantly, the resulting Size Index has a high correlation to the U.S. large-cap market portfolio as defined by IVV (Barclays iShares Core S&P 500) but with statistically significant outperformance as shown in the following chart.

Remember, this is being accomplished by holding just 50 stocks and not the entire S&P 500.

One might naturally think that given that U.S. large caps are among the most owned securities in the world it would be impossible to gain a performance edge. But remember, this edge comes from a more thoughtful process to the index construction itself.

What is exciting is this same process can be applied to any size basket or factor that an investor seeks. Similar results with small and mid-cap stocks, international stocks, and dividend stocks have been obtained.

The practical application of this is through technology that allows direct indexing, now widely available, which makes it extremely easy for investors to apply these types of index strategies at the account level.

In addition to the added performance, direct indexing allows for tax loss harvesting and individual customization… benefits not found in traditional passive index products such as mutual funds and ETFs.

For investors who are seeking targeted market exposure, these new approaches to index investing offer many benefits to consider.

Until next time,

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