November Newsletter: Is Indexing on the Decline?

Posted by Alex Frey (@alexhfrey )

If you had to express the IvyVest approach to investing in three words, they would be: simplicity usually wins. Nowhere is this more true than when it comes to index funds, where buying and holding a single security is often an overwhelmingly superior strategy than trying to pick stocks.

Long-time readers know that we are constantly re-evaluating the assumptions that we hold about the market – we think that this is actually both a pre-requisite to investing well, and also one of the biggest reasons that so many people fail at investing. The easy thing to do is to scour the news every day for the commentaries or pieces of new information that support your pre-existing hypothesis – it takes real effort to do the opposite.

This month our bias to finding articles that disagree with our view of the markets brought us to a NY Times article titled “The Ease of Index funds Comes with Risk”. The article suggested that maybe index funds have become too popular and that this is driving up the price of stocks in the major indices. If this is true, then purchasing the ETFs that form the backbone of the IvyVest strategy might no longer be the best way to invest. Or, to put it differently, the simple approach may no longer be the best approach.  This would be a pretty serious change – so it's worth reviewing why we subscribe to the indexing philosophy in the first place and if it continues to make sense.

The Case for Index Funds

The simplest case for index funds is that they just work. In the past, they have outperformed the vast majority of actively managed funds over any long-term period. In his book “Stocks for the Long Run”, Jeremy Siegel compared the returns of all funds and “survivor” funds versus the S&P 500 index and the Wilshire 5000 index over the period from 1971 to 2006. “Survivor” funds are funds that were still operating at the end of the period. All funds includes funds that went out of business, perhaps because they had low performance. Siegel’s data is shown in Table 1 and shows that the indices outperformed both types of funds over this period. Other researchers have made similar observations using other historical periods.

Table 1: Annual Returns (%) of Indices Versus Managed Funds (taken from Stocks for the Long Run by Siegel) 

All Funds “Survivor” Funds 

Wilshire 5000 All funds –Wilshire 5000 “Survivor” funds-Wilshire 5000 10.49 11.29 11.55 11.53 -1.06 -.26

All Funds "Survivor Funds" S&P 500 Wilshire 5000   All Funds - Wilshire 5000 Survivor Funds - Wilshire 5000
10.49 11.29 11.55 11.53 -1.06 -.26

The reason that the index funds have outperformed in the past is their low cost. In essence, index fund investors get the benefit of the research done by active managers without paying for it. The active managers are constantly searching for under and over-valued stocks, and by buying and selling on the basis of their research they adjust stock prices to fit the changing reality for companies. Index fund investors essentially get to 'free-ride' on the back of this.

However, as indexing increases in popularity, one can guess that at some point the active managers will gain an advantage over those who sit back and accept the prices that the market delivers. Are we approaching that point now?

In a word -- no.

Index Funds Still Have Minority of Assets

There is no question that index strategies are getting more popular. Figure 1 shows the cash flows into and out of equity funds. Indexed funds and indexed ETFs are experiencing positive flows while actively managed funds are experiencing net redemptions.

But though index fund assets are growing, it is from a low base, and they still represent a relatively small fraction of the total assets out there. The Times article cites a figure that 30% of ETF and mutual fund assets are now using indexed strategies, but ETFs and mutual funds themselves only hold 24% of total stock market assets. Figure 2 shows how share ownership has been changing over time.

Randall Smith, writing in the NY Times, said that only 19% of public pension funds and 11% of corporate pension funds were indexed. So although we don’t know precisely how much of the total market is indexed, it is almost certainly less than one third and probably less than 20%.

fig1.jpg Figure 1: Cash Flows into (+) and out of (-) equity mutual funds.

fig2.jpg Figure 2: Ownership of the Domestic Equity Market

The Real Issue: All indexes are not created equal

Though 20% or less of the total market in passive assets might not be enough to make the price mechanism stop functioning, could it be enough to push up the prices of stocks that are included in an index relative to those that are not? In this case, it might be a better strategy to explicitly buy stocks of non-index companies.

There is some evidence that this is true when you look at the landmark S&P 500 index in the US, the most common "large-cap" index that funds track. The Times article cited research by S&P Capital IQ that stocks inside the Russell 2000 were more expensive relative to the assets they had on their books (price to book ratio) than stocks with similar capitalization that are of outside the index. It also stated that there is an upward bump in the price of a stock when it is added to the S&P 500 index. This was also noted by Siegel, who said that that stocks added to the S&P 500 index got an average bump of 8.98% over the next year relative to the market as a whole.

These are interesting results, and seem to suggest that buying the S&P 500 alone might come with some performance drag, while buying smaller-cap companies that are likely to soon enter the S&P 500 could potentially be a profitable strategy (though with these results widely disseminated and many investors likely now trying to do this, this effect will probably soon disappear). But the results do not question the efficacy of buying the kind of total stock market index fund recommended by IvyVest.

To see why, we need to dig a bit into how indices are constructed. The Standard and Poor’s 500 (S&P 500) is composed of 500 large capitalization, mostly U.S. stocks. Some people presume that it is a list of the 500 largest U.S. stocks, but this isn’t true. The stocks are selected by a committee which looks at several factors, including capitalization (total value of the issued stock), volume of trading, financial viability, economic sector, the exchange where the stock trades, and other factors. The index is periodically updated to allow for mergers, spinoffs, bankruptcies, and changes in market value.

The fact that there is some selectivity in the choice of stocks for the index allows one to compare firms with similar capitalization that are inside and outside the index. It also means investors are not strictly getting the return of "the market" or of a particular sector of "the market" -- they are in fact getting the capitalization-weighted average return of the 500 stocks that were selected to be in the S&P 500. In a sense then, buying an S&P 500 index fund is not altogether different than buying an actively-managed fund (except, of course, that it generally comes with much lower expenses) -- and in this case it is an actively managed fund that has the disadvantage of being largely predicable in its trading.

By contrast, larger indices like the Russell 3000 and Wilshire 5000 (which form the basis for most 'total market' funds) are purely capitalization-weighted constructions. So these funds are virtually guaranteed to get a 'market average' return, and that market average return is mathematically almost guaranteed to beat the average active investor's returns once fees have been deducted.

The proof of this pudding is looking at more recent data comparing index (passive) funds and actively managed funds. Morningstar has an “Active/Passive Barometer” that can be used to make this comparison. Figure 3 shows Morningstar’s data for the percent of active funds that beat a composite of passive index funds (including ETFs) that invest in the same category of stocks. The comparison is made for different Morningstar investment categories and for the previous 1, 3, 5, and 10 years. For the 10 year case, Morningstar also breaks out the cheapest (lowest management fees) quartile of active funds and the most expensive quartile. For the data in Figure 3, the time period ended on 31 December, 2014. There is no obvious trend in the data that would indicate that indexing is losing its value. For most categories and most time periods, the composite passive fund beats the majority of actively managed funds. As one would expect, the cheapest quartile of active funds far outperforms the most expensive quartile.

fig3.jpg Figure 3: Morningstar data on the percent of actively managed funds that beat a composite of passively managed funds (index funds).

At this point, some readers may say, “Well, I’ll invest in one of the active funds that beats the index”. The problem with this has been explained many times by many people. The problem is that “Past performance is not a guarantee of future results.” The fund that performs well in the next period is not necessarily the one that performed well in the last period.

Everything You Thought You Knew Is Not Wrong

The markets are some of the most dynamic vehicles on earth, and it's always good to be on the lookout for changes. And there could come a day when so many people are investing in index funds that active investors actually gain an advantage. But that day is not today. 

Indexed assets continue to account for a vast minority of total assets, and index funds have kept up their track record of outperforming active funds over the long-term. 

The demise of indexing may have been exaggerated, but critics are right that index construction matters. Whenever possible, investors should invest in a total-market index fund, the only truly "passive" option that is available. 

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By Alex Frey