Is the Tide Going Out on Those Naked Index-Investor Swimmers?

There is no question that index investing has been enormously successful recently, especially in the aftermath of the 2008 meltdown. This style – also called “passive” because there is no attempt to pick superior stocks as in the “active” school – is exemplified by low cost mutual funds like Vanguard, cheap ETF’s, and the “new” robo internet platforms like Betterment, WealthFront, and likely new offerings from across the tech jungle from players like Amazon. “No one is smart enough to know in advance which stocks will outperform,” as the logic goes, “so don’t even try! Just buy the whole market by using cheap index funds, and you will do better with almost no work!”

Perversely this has turned out to be true for the past decade or so, a long enough period in human brain function to make a random fluctuation or coincidence appear to be natural law, as true and constant as the speed of light or the acceleration due to gravity. Of course, this is an illusion. The only constant in human discourse or commerce is inconstancy, and to believe that the collective actions of hordes of irrational, poorly informed, distracted and conflicted human brains – and this is a pretty good definition of a market, when you think about it – could be otherwise is lunacy. But people irrationally tend to extrapolate the recent past into the future, and often get burned when the world changes unbeknownst to them. So while many may believe that passive investing in cheap indexes is now proven to be the smart way to invest, here is why you should not. We will explore the S&P 500 Index, the chief god of the passive acolytes, though the logic applies to most indexes in some degree.

The first important concept is that the S&P 500 is a market cap weighted index. This means that the index’s value is a function of each stock’s value in the market, the number of shares trading times the stock’s price. To use a simple example, let’s say the Ludicrous 500 stock index initially starts with 500 companies, each with one share trading in the market, each worth $1 per share. So at the start, the index is equal to $500. Now say one stock – let’s call it Gigantazon – really soars, to $1000 a share, but the others are unchanged. The index is now at $1499. We have 499 stocks at $1, and 1 at $1000. Most index investors will be pleased the index tripled, but most will not know it was entirely due to one stock’s meteoric rise, or that Gigantazon may have been grossly overvalued, or that their index investment is now so wildly and perhaps dangerously concentrated in only one stock, whose index value is actually greater than the other 499 stocks combined! For index investors who buy the index after GZON’s run up, and who think they are smartly diversified, a rude awaking may be in cards if, say GZON’s profits go way down, its risk goes way up, or it is attacked for going postal.

The second important thing to note is that stocks are NOT selected for the S&P 500 index based on investment merit! The index uses specific guidelines intended to help make sure that US large cap stocks are represented. The good, the bad, and the ugly, not the best. Changes occur based on the index committee’s opinions of how well the current mix meets these guidelines, not to improve returns.

The third and final point I will make is that inclusion and deletion from an index can result in severe market distortions. Changes to an index are typically announced several days in advance of the actual change. Traders will want to front-run the changes, and typically buy additions and dump deletions soon after the announcement. But fund managers, who have mandates to minimize “tracking error” (in other words not try to beat or underperform the index, just track it closely) generally will seek to buy additions and sell deletions when the index actually changes, not when the announcements are made. This can cause index funds to pay far more for replacement stocks, and get far less for the stocks they replace, than the market prices just a few days before when the announcements are made. Since there is so much in index funds – about $3,600,000,000,000 of aggregate investor dough estimated as of April of 2017 – these distortions can create huge supply/demand price changes totally unrelated to stocks’ actual investment merits or fair pricing. This can really destroy value, in Camarda’s view, in a way totally invisible to most investors. On the other hand, adept traders, knowing the future before it happens, as it were, can buy additions (and short deletions) at favorable prices, then dump them on (buy them from to cover) the index funds who are forced to make the changes at whatever price, on terms which can be very favorable to traders and adverse to fund investors. On S&P 500 funds, with so much investor money in so many ETFs, mutual funds, and other investment vehicles, the trading volumes are huge and the market distortions potentially quite severe.

For these and many other reasons, we think index investing poses many unappreciated risks, and that millions of Americans may be in trouble if the tide, as we believe, has begun to reverse and run out. If you – or friends and family that you care about – might be exposed to this hard to spot risk, please contact us for a free portfolio stress test, and we can share our insight and advice with you or them, on the house.

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