The Planner's Perspective: The Indexing Paradox
By Paul Morrone CFP®, CPA/PFS, MSA
Indexing has been a very hot topic in the investing world as the popularity of index funds and ETFs have proliferated in the market at a record pace. The allure of low costs, diversification, and an understandable investment philosophy makes indexing one of the most popular investment choices for the masses. On the surface, the concept appears pretty simple – your investment is designed to follow a published index such as the S&P 500 that is plastered all over TV and the internet. However, when you peel back the onion there is a lot more going on than what first meets the eye.
Into the weeds for a minute. To understand indexing, you need to first understand what the index really is, because there is not a lot continuity in how any of the various indices are calculated. It’s also important to note that it is impossible for anyone to invest directly in an index, this must be done through investment vehicles such as mutual funds or ETFs (i.e. index funds). The S&P 500, for example, represents the weighted performance of the 500 largest publicly traded companies as defined by market capitalization. By weighted we mean that that the larger the company’s market cap, the more impact the performance of that stock has on the index overall. In fact, just 5 stocks (Apple, Microsoft, Amazon, Facebook and Google) account for over 10% of the entire index’s performance. This contrasts sharply with an index such as the DOW Jones Industrial average, which is a composition of only 30 stocks and is calculated on a price weighted basis (where Boeing is the most heavily weighted company).
Ok out of the weeds. The more thought provoking question, however, is do you want to own all 500 of those companies, and if so, do you want to own all 500 of those companies all the time? Index fund managers have absolutely no discretion when selecting the stocks that are owned by their fund or ETF. Why? Because the index is created by a third party (i.e. the S&P is created by Standard and Poor’s) and an index fund must mirror the holdings and their respective weights in the index exactly.
While diversifying your investments is a tried-and-true investment philosophy, who’s to say that those 500 companies are the right ones for you to own. Some socially responsible investors may not agree with the corporate governance of some of the S&P 500 companies. Maybe those companies employ unfair labor practices, or deal in alcohol, firearms or tobacco. Maybe they are pharmaceutical companies that manufacture drugs that are against your religious beliefs. Others may want exposure to other markets that represent different opportunities and risks. Of the over 600,000 stocks available worldwide that one can purchase on the open market, there may not be a good reason to limit your investments to just the S&P 500 or the 30 stocks of the DOW.
As with any investment program, there is no one size fits all approach. While indexing may be a cost-efficient way to gain some ‘market’ exposure, we note that these types of investments are not without risk. In many ways, investments in indices can produce more systematic risk than funds or portfolios in which managers have discretion as to which risks to take and which to avoid. The autonomy granted to an asset manager may allow them to selectively take on specific risks that are prudent based upon an individuals’ investment objective, risk tolerance and time horizon, which may or may not include index-based investments. A consultation with a professional may help you determine which approach is in your best interest rather than blindly assuming basic market risk through an index fund.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Investing involves risk including the loss of principal.