Sullivan's Market $ense: An investment column offering perspective on today's market noise
Index Investing Ups and Downs
Through the years index investing has had its ups and downs. Sometimes the methodology is helpful and sometimes it isn’t. I think we are on the cusp of one of the bad times.
Index investing is an effort to replicate the performance of an index. The index may be a broad index like the S&P 500, or a specific sector index like Renewable Energy. There are even bond indexes which have index funds or strategies following their every move. Managers trying to replicate an index as broad as the S&P 500 must own many stocks, if not all 500, and try to keep the money they manage aligned with the index. A major draw of index funds is their fee; the fee charged tends to be less than that of actively managed funds. If the goal is to perform like a particular index, these are good vehicles. At times and in particular sectors, indexes are easily bested by active managers.
Indexes are naïve to their surroundings. Index funds are equally naïve. A bond index fund in 2010, 2011, 2012 and 2013 did not know we were in an economic recovery and that corporate profits were climbing. Active managers knew this. A bond index fund did not know during this period that the Treasury was increasing its debt issuance to $1 trillion a year. Active mangers knew this. Active managers reduced their holdings of the plentiful Treasury bonds and bought the scarcer, and improving, debt of US companies. As the US Treasury issued more and more bonds, the index funds continued to buy greater and greater amounts--because their mandate is to own bonds in proportion to the amount issued. Compared to a few years ago, index funds have a greater proportion of their assets invested in US Treasuries and a smaller amount in US corporate bonds. US corporate bonds have naturally provided the better returns during this period. It is clearly counter to logic to invest more and more heavily in the biggest debt issuers. If GE were to decide to repay half of its debt and become a substantially better rated risk, an index fund would make it a smaller part of its portfolio. On the other hand, were GE to double its debt, index funds would double the size of their commitment to GE. This makes for an interesting interplay: escalating risk at the company being compounded by escalating exposure at the index fund.
Stock indexes are generally capitalization based. This means they own a proportion of a company’s shares based on the value of that company. So for an S&P 500 index, the largest weights are in GE, Exxon, and Apple. An equity index fund would be similarly structured. Stock index funds perform best when the largest parts of the market are also the better performers. Because the weight of the stock in the index is based on its value, an index fund “buys” more and more of the stocks which are climbing in value. Therefore, a stock which climbs and climbs will be a larger and larger part of the index. This is also true for sectors. When energy was hot in the 80’s, it became the largest part of the index. In the 90’s, when technology was the rage, tech was the biggest part of the index. Since the beginning of this recovery, the fastest growing sectors have been consumer discretionary, finance, and technology. They are now a bigger part of the index than they were before their run-up. If you had bought $1,000 of an index fund at the end of ’08, it would have been 8% consumer discretionary, 13% finance and 15% technology. Buy it now and it will be 12% consumer discretionary, 16% finance and 18% technology. You see, index funds don’t know about “buy low, sell high.”
Cycles are a large part of how stock analysts think about the market. All things are cyclical, including politics, economics, and especially stocks. In the stock market it is an everyday occurrence for some stocks to be well over valued and ready to slide back, and for others to be oversold and ready to surge. Stock analysts sometimes refer to stocks as early cycle or late cycle. By this they mean the stocks which tend to perform best in the first part of a recovery, compared to stocks which tend to do best in the last part of a recovery. We have been experiencing a very slow moving recovery and bull market. We are only just now starting to see a transition from early cycle stocks (consumer discretionary, finance) to late cycle stocks ( industrials, materials). Unfortunately, indexes, index funds, and index investors are naively unaware of this transition, and more heavily invested than ever in the sectors with the least value and the highest prices. To exacerbate their problem, they are also least exposed to industrials and materials just when it is their time in the sun. An active manager, recognizing this transition, will have a tail wind to help his performance, while indexes and index funds buck the headwind of over exposure to last year’s winners.
Brian B. Sullivan, CFA
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