Reinventing the Index
One of the simplest investing strategies is getting more complicated.
By David Landis, Contributing Editor
From Kiplinger's Personal Finance magazine, October 2006
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As investors suffered during the bear market that began in 2000, Rob Arnott struggled to understand why anyone would call it a bear market in the first place. True, Standard & Poor's 500-stock index dropped 25% from its March 2000 peak through the end of 2001. But Arnott, a California money manager and editor of Financial Analysts Journal, observed that the average stock traded on the New York Stock Exchange rose 20% during the period. If it was an up market for so many stocks, why, he wondered, did investors lose heavily by owning funds that track the S&P 500 and other popular indexes?
This question is fueling one of the fiercest debates about index investing since it first became popular 30 years ago. The dispute isn't about whether indexing, in contrast with owning actively managed portfolios, is a good idea. Both sides agree that it is.
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Rather, the argument is about the nature of the indexes themselves. Critics of the S&P 500 and other widely used barometers say the indexes are inherently flawed because they are dominated by a handful of companies and because they must, by their very nature, add more shares of stocks that are rising and trim positions in stocks that are falling. Therefore, as investors move money in and out, managers of index funds are forced to buy stocks when they are overpriced and sell them when they are undervalued. If they don't trade, their funds no longer replicate the index they promise to track.
A brewing debate
Experts such as Arnott contend that the new generation of index funds, built on more sophisticated techniques, still provide diversification and low cost -- but with better returns and less risk. Defenders of the old order say the advantages of the new indexes are illusory because they are skewed toward stocks that have excelled lately but aren't certain to do well in the future.
Who's right? It's too soon to tell. But the new indexes are backed by formidable intellectual heavyweights. And funds that take the new pathways are starting to pique the interest of ordinary investors. "I think they are an interesting concept," says Donald Sonn, a Northampton, Mass., doctor who keeps virtually his entire portfolio in index funds and is considering investing in some of the new offerings. "Some companies can totally dominate an index fund," he says, "and that can put you more at risk. Spreading the risk can be beneficial."
Are new-generation indexes truly less risky? Let's take a closer look.
Like most indexes, the S&P 500 holds stocks in proportion to their market value (share price times the number of shares outstanding). So its holdings of the biggest company, ExxonMobil, with a market value of $415 billion as of mid August, are roughly 729 times greater than its holdings of number 500, Gateway, a $569-million firm.
You don't need a PhD to understand why it works this way. To own a representative sample of the market -- the purpose of indexing -- you need more shares of larger companies and fewer shares of smaller ones. Often, this results in index-fund managers buying more shares of companies as their prices rise, even if those shares are already expensive. At the same time, they must sell stocks that are out of favor even if they are well priced to buy.
This was a serious problem as the bull market neared its end in early 2000, when investors drove the prices of huge companies, such as General Electric, to extremes (it wasn't just a technology bubble). At the end of 1999, the ten biggest companies in the S&P 500 had a collective value of $3.1 trillion, more than one-fourth of the index's total. The ten biggest companies today are worth just $2.3 trillion, so the S&P 500 is no longer as top-heavy. The top ten account for just 20% of the index's value now.
By the way, the top ten stocks from 1999 are worth just $1.8 trillion today. That $1.3 trillion in lost wealth tells you that large-company stocks (and the indexes that measure them) have been dogs for years. No wonder critics say the shortcomings of traditional indexing are chronic, even if they aren't acute at the moment. And they say the shortcomings extend to all indexes that are weighted by market value. Those include the small-company Russell 2000, the Wilshire 5000 and others. If you own a fund that tracks a market-weighted index, "you can be absolutely assured that most of your money is in overvalued companies," says Arnott.