Investopedia defines an index as: “a method to track the performance of some group of assets in a standardized way. Indexes typically measure the performance of a basket of securities intended to replicate a certain area of the market.” (source)
The purpose of indexing is to measure the performance of an investment or portfolio of investments to a group of similar investments. In fact, the word index comes from a Latin word meaning “to point out”. Therefore, the job of the index you are comparing your investments to is to “point out” whether your investment is doing better than average, or not… and therein lies the problem, and why I think we should rethink indexing.
As a concept, indexing is a fantastic idea. It makes perfect sense to compare your investment to other similar investments to see whether you should keep yours or sell it and buy something else. The problem is most people compare all their investments to one index… the S&P 500… which at first glance seems to make sense… but indeed makes no sense if you understand how the S&P 500 works. Let me explain…
S&P 500: The Perfect Index?
The S&P 500 is a basket of the top 500 stocks (or companies) in the USA based on market capitalization (the current value of all a company’s public stock) … Most people have stocks in their investment portfolios… so doesn’t it make sense to compare those stocks to the S&P? Some of them, yes, but almost certainly not all of them.
You see, there are different classes of stock and different sectors of stock, and they have very different performance and volatility expectations. Therefore, for comparing, you should select an index with a composition similar to your portfolio.
Classes: Stocks (companies) are commonly divided into groups based on their “market cap”. The most common categories are “small cap”, “mid cap”, and “large cap”. The amounts that determine where a stock ranks change over time, but the idea is that the larger a company’s market cap, the less likely it is to file for bankruptcy and therefore the lower your risk of losing your investment. But remember the risk/reward trade-off! You should not expect a large “low risk” company to produce returns like a small “high risk” company!
Sectors: Stocks (companies) are commonly divided into groups based on their industry. The 11 broad sectors most commonly used are energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, telecommunication services, utilities, and real estate. The key thing to realize here is that all sectors do not perform the same. A utility company is not going to produce returns like an information technology “tech” or consumer discretionary company!
Because the S&P 500 that everyone hears about is cap weighted… and the biggest, shiniest, stocks have been getting all the love here lately… 24.4% of the index is now* comprised by 5 companies! Apple, Google, Microsoft, Facebook, and Amazon.
Now we all know our portfolios are supposed to be diversified (not putting all your eggs in one basket) to reduce the risk of losing a lot of money if one sector takes a hit (ea. hospitality during COVID-19, or real estate in 2008.). If we’ve been smart, the composition of our portfolio looks nothing like the S&P 500… AND THAT’S A GOOD THING. So then, it simply doesn’t make sense to compare apples (a wisely diversified portfolio) to oranges (a tech-heavy basket of stocks based purely on size). Yes… they are both fruit, but they look, smell, and taste very different.
To be clear, indexes are not the problem… rather, the way they are used and the lack of public education on the subject is the problem. In the mind of the retail investor, every investment under the sun is measured against the S&P 500.
Compounding the problem is the fact that anyone can create an index and change that index as they see fit. There are a myriad of indexes for all purposes, with convoluted names that use industry jargon. So the retail investor would exhaust themself trying to find a suitable index. Therefore, they end up using the S&P 500 simply because it is plastered across every media outlet that covers finance.
But enough about the problem. What’s the solution?
The solution is to create better standards and regulate the use of indexes. Also, a disclosure should be prominently displayed when using an index that explains, in 1 or 2 paragraphs and plain English, how the index is composed and what type of investment(s) it is designed to be compared with.
An ideal scenario would be for an uninterested government agency to create and maintain standard non-cap weighted indexes for various purposes and require the appropriate index be used in given situations… but that will probably never happen because people hate the government, and regulation lol.
Without change, the public will continue to make misguided decisions based on incomparable indexes.
If you are an investor, I implore you to examine and understand the composition of your investments and compare it to a suitable, similar index.
If you are a Financial Professional, I petition you not to succumb to the convenience of using the S&P 500 for everything and educate yourself on what indexes are available and when they are appropriate. A couple of fantastic resources are: https://www.ftserussell.com/index/category/equity and https://www.spglobal.com/spdji/en/index-family/equity/
The 2020 financial crisis and subsequent “recovery” is a perfect example of the exaggerated effects of investing guided by improper indexing. Share this article with someone smart enough to understand and make the financial market a wiser, wealthier place.
*as of 10/2020
All investments carry a measure of risk and may lose value. Always consult a Financial Professional before making any investment decisions. (Find a Financial Advisor)
Copyright © 2020 Ross Kline. All rights reserved.