Hope over experience?—S&P Indexology

I subscribe to the S&P Indexology blog.  It’s written by S&P staff involved in manufacturing the company’s well-known financial markets indices.  Usually it’s interesting, although the writers’ true-believer conviction that no active manager is capable of matching–to say nothing of outperforming–his benchmark index often shines through.

Yesterday’s post, titled “Hope over Experience, ” is a case in point.  It takes on a recent, pretty silly Wall Street Journal article that muses about an “Old-School Comeback”  of active stock mutual fund management, based on recent outperformance of the average active manager over the S&P 500.  “Recent” in this case means the first four months of 2015; “outperformance” means a gain of .33% versus the S&P.

The obvious observations are that the time period cited is extremely short and that the gain versus the index is probably statistically insignificant.  S&P Indexology goes on to say that the comparison itself is bogus. The S&P 500 is neither the appropriate or the actual official benchmark for many stock mutual funds, which have, say, growth, value, small-cap or other mandates and other benchmarks than the S&P 500.

So far, so good.

Then come two comments straight out of the university professor’s playbook:

–The first is the argument that because an active manager’s portfolio structure may be dissected, after the fact, into allocations that could have been replicated by indices, actually creating and implementing that structure in advance has no value.  That I don’t get at all.

–Indexology concludes by suggesting that because investing in the aggregate is a zero-sum game–the total winner’s pluses and losers’ minuses exactly offset one another, before costs–there can’t be any individual investors who consistently outperform.

I believe that life in general, and investing in particular, is a lot like baseball.  (I’ve been thinking about baseball recently because it’s in season).  The second Indexology comment is much like saying that the Giants’ winning three World Series in five years is a random occurrence.   …or that the change in ownership of the Cubs and the hiring of Theo Epstein have nothing to do with the club’s success this year.  Yes, bad teams get a preference in the draft each year, but the end to a century of futility?

…and what about the Braves and Cardinals, who consistently field above-average teams even though their draft positioning does them no favors.

To be clear, I’m an advocate of index funds.  My reasoning for this is not that outperformance is impossible (the ivory tower orthodoxy) but that it takes more time and effort than most people like you and me are willing to put in to locate and monitor active managers.  I’d be much more comfortable with Indexology saying this.

types of stock indexes

Indexes can be categorized in several different ways, including:

reach, or coverage

geographical

There are broad market indexes like the S&P 500, which cover all the important sectors and contain all the key large-capitalization stocks within a geographical region.  In this case it’s the US.  There are similar indexes for all the other major–and most minor–stock markets of the world.

There are also indexes that cover larger geographical regions, like North America, the Americas, Europe, the EU, Greater China, Asia, the Pacific…

There are also indexes like EAFE (Europe, Australasia and the Far East), which covers the world ex the US and Canada.  It’s purpose is to provide a benchmark for foreign stock portfolios held by US or Canadian investors.  There are similar indexes for the World ex Japan, World ex UK…

sectoral

There are also indexes that focus on specific sectors or industries, sometimes divided into local and foreign, depending on the portfolio being measured.

size

There are also indexes that focus only on mid-cap or small-cap stocks, like the S&P 400 (mid-cap) or S&P 600 (small-cap).  With these, the definition of what counts as mid-cap and what’s small-cap may vary from index provider to provider.

investing style

Personally, I find these more problematic, but there are also indexes that claim to contain only value stocks and others that contain only growth stocks.  The sectoral composition of such indexes can deviate wildly from each other, as well as from a larger, style-neutral index.

how the index is calculated

Virtually all today’s stock market indexes are capitalization-weighted.  That is, the effect of the price change of any given stock in the index is based on the total market value of all that company’s outstanding shares.  Stocks where this value is large have more influence on the index movement than whose where the value is small.

Example:

Let’s say the index contains three stocks, whose value totals 100.

Stock A has a market value of 70

Stock B has a market value of 20

Stock C has a market value of 10

On a given day, A rises by 1%, B by 2%, C by 3%.

The change in the index is calculated as follows:

(.7 x .01) + (.2 x .02)  + (.1 x .03)  =  .007 +.004 + .003  =  .014

The index rises by 1.4% that day.  The greatest influence on the index performance is stock A because it’s much larger than the other two.

A variation on capitalization weighting is free float weighting.  It may be that in a given country, the government or a powerful family owns a large chunk of one or more large-cap stocks.  The part that’s so held is never traded.  It’s said not to be part of the pubic “float.”  Where this is the case, indexes often weight the stock using only the float, not the full market capitalization.

variations

equal weighting

The Value Line index is an example.  In an equal weighted index, all constituent stocks count the same.  In the example above, an equal-weighted index would be up by 2%.

Versus a capitalization-weighted index, an equal weighted one gives much greater emphasis to smaller stocks.

the Dow and Nikkei Dow

These indexes are wacky.  They use the per share stock price as a weighting factor.  In other words, a $100 stock counts for 10x what a $10 stock does, no matter what the total size of either company is.  To my mind, this is sort of like saying a nickel is worth more than a dime because the coin is larger.

“fundamental” weighting

At one time in the recent past, some investment managers claimed they were offering an index product in which stocks were selected as index constituents either because they had a strong record of high and increasing dividend payments, or because they combined strong earnings growth with modest stock market valuations.

To my mind, this is a marketing ploy.  These are active management offerings, not index funds/ETFs.  The active manager has decided to rely exclusively on mechanical rules that embody his investment judgment.  Many value managers do much the same thing.

As far as I can see, the investment managers I’ve heard making index claims for their products have stopped doing so–with or without the prompting of regulators I don’t know.

stock indexes and indexing

what stock indexes do

Stock indexes have two main functions:

1.  They provide information about how stocks in general are doing.  Part of this is that it’s nice to know, sort of like the weather. But that’s not all.  The broad stock market has an important role in macroeconomic forecasting.  In the US, the stock market is historically the most reliable leading indicator of economic activity.  Even in today’s world where half the market’s profits come from abroad, changes in stock market direction tend to accurately foretell changes in economic growth that occur around six months later.

2.  Indexes serve as measuring tools to assess the performance of professional money managers.  Three factors have made the role of benchmark increasingly important:

–the widespread rise, post-WWII, of pension plans for workers,

–The Employee Retirement Income Security Act (ERISA).  This Federal legislation, passed in 1974, set down strict standards for corporate stewardship of employee pension plans, and

–rising affluence, which has transformed stock market investing from the exclusive province of coupon-clipping bluebloods into an arena where middle-class Americans can, and do, participate.

academic research on active management

Most of the finance taught in universities is pure nonsense, in my view.  The real world is much more complex than professors realize.  Nevertheless, academics do do good empirical research studies.  One of their most devastating findings is that the typical professional, or “active” investment manager in the US routinely underperforms his benchmark index.  Almost no one outperforms after deducting the fees he charges for his services.   Ouch!  (As it turns out, my portfolios generally outperformed, but I usually ran portfolios that had large exposure to foreign markets–which are another story).

Once ERISA forced pension funds to pay attention, they quickly learned this lesson.

Hence the rise of index funds, which track very closely the performance of benchmark indexes like the S&P 500 and have extremely low costs.  That’s “low” in the sense of better performance than an active manager, at far less than 10% of the costs.

lots of index providers

Standard and Poors has a whole slew.  So does the Financial Times.  Pension consultant Frank Russell has a bunch, too.  And MSCI.

Why so many?  

–They’re profitable.  They’re also relatively easy to set up.  All you need is the money to hire a few quants and a giant computer.

–The first guy in collects the most assets.  Therefore, unless he really messes up, he should have the lowest costs.  And as a result of that, he should get the majority of new inflows.  So it’s much, much better to have an index fund product a little in advance of any demand.  Being late to the party is devastating.

they’re all a little bit different

The FT index for large-cap US stocks has somewhat different constituents from S&P’s;  both are different from Russell’s.  That’s to make it more expensive for large institutional clients, who may pay only a few basis points per year in fees, to switch among index fund providers.  So they can’t play one provider off against the others and bargain for lower fees.

More tomorrow.