Week in review 3/30 The Trouble with Indexing
by Zach Marsh on Mar 30, 2018
Weekly Notes: Benchmarks and the Trouble with Indexing
"Tryin' to make it real, but compared to what?"
The next few weeks I thought I'd talk about benchmarks and how we can measure portfolio performance or success in a goals-based investment plan. Money managers and hedge fund managers track indices as a method of measuring their performance. They prove their value to investors, pension fund advisors, and other wealth advisors by trying to beat the performance of a relevant investment benchmark. For example, large-cap stock managers are measured against the S&P 500, while bond managers are measured against the Barclay's Aggregate Bond Index. While this can work well as a way of measuring relative performance in an apples to apples sort of way, it can be short-sighted and flawed because many random factors effect returns over shorter term periods. We may consider one to two years an adequate time horizon for measuring relative performance, but considering the average business cycle is roughly 5-6 years, even two years is a short time period.
Chasing performance by allocating to investments or funds which have recently outperformed creates a recipe for disaster. Funds, or investments, that have performed well over a recent period may be structurally designed to outperform in that particular climate, but will underperform in the environment that may be just around the corner. That being said, active fund managers' track record of consistently beating the index, over any concerted period, has been notoriously scrutinized over the past 20 years. The growth of the passive, Index based Exchange Traded Fund (ETF) industry in the last 10-15 years illustrates this shift from the idea of index beating to index performing. Investors have concluded: If you can't beat 'em join 'em. But this brings me to the first problem of benchmarking and indexing: choosing the right one.
Who is this Guy We are Following?
If you were going to climb Mt Everest you'd probably be in the market for a good Sherpa. You'd want to know he knew what he was doing and where he was going. You'd also want to know that he was cautious and not willing to take unnecessary risks. It would also seem like this would be prudent advice in choosing a benchmark for your portfolio measurement. But unfortunately this isn't necessarily the case. The S&P 500 is the most widely followed benchmark on the planet. When people ask: what did the market do today, most likely what they are asking is what did the S&P 500 do today. The S&P 500 index is made up of the largest 500 stocks listed on the NYSE and NASDAQ stock exchanges. Each company's weight, or importance, in the index is measured by its market cap, or roughly its overall size. Larger companies, like Apple and Amazon, have more weight and effect the price of the index than smaller companies like Foot Locker or H&R Block. It may seem prudent and reasonable to allocate more weight to the larger companies, but if your goal is diversifying, this weighting system can be counterproductive.
Over the past few years, as the stocks of well-known tech companies have exploded in value, so to has their influence on the value of the over all index. Currently, five companies (Apple, Microsoft, Amazon, Facebook, and Google) make up nearly 14% of the S&P 500 index weight. This has been extremely beneficial in recent years for holders of index funds, as the rocketing share prices in these companies has had a strong impact on the index as a while. But, it has also set in place a feedback loop, where more people allocate to index funds, index funds allocate to underlying companies (each according to its weight), and the underlying stocks receive investment money regardless of their current value or business prospects. In fact, the greatest contributing strength for these companies is their size. Currently, the Price/Earnings ratio (measurement of anticipated growth, or hope, relative to current earnings) of these 5 companies, as a whole, is nearly 3 times higher than the P/E ratio of the remaining S&P 500 index. This means that when the tide turns on the narrative, either the narrative of growth or the narrative of love of all things technology (looking at your Facebook and Amazon), when this happens the tide will definitely drag the "broad" based market with it. With market cap weighting, You Live by the Sword and You Die by the Sword.
The narrative is powerful in financial markets and it can be a big driver of both positive and negative performance. What causes narrative to shift and turn is nearly impossible to predict. Benchmarking oneself to an index that dances in the wind of shifting narratives unnecessarily subjects oneself to "good timing," or being in the right place and the right time. Therefore, it is important we look for other ways to measure our performance rather than benchmark indices, fraught with danger and unpredictability, like a drunken Sherpa.
To be continued...
Now to the Benchmarks
For the Quarter:
S&P 500 -1.2%
10 Year US Bonds -1.8%
Cboe Volatility Index +80.89%