Under the Hood Index Series

Indexation is unique inasmuch as there is no forecasted return associated with indexation. If the S&P 500 were to decline by 50%, this does not invalidate indexation. There is no consequence for the index, it’s merely the return that the index produced — it can’t underperform itself. Active managers, however, are evaluated relative to the index, though it is effectively impossible for active managers in aggregate to outperform the benchmark. What is necessary, then, is a departure from the investment behavior generally exhibited by active managers. They must be willing to eschew diversification to allow high conviction investments to grow as a share of their portfolio. In essence, they must behave in ways that the index cannot. Included herein are two of the best-known stocks in the world that anyone could have bought and held for a one or two decades and become the top performing manager of their era. Not only didn’t any active manager do that, neither did any index, but nor could any index have done so.

No concept in the investment world is as accepted as diversification. It is the most fundamental element of risk control. Almost by definition, active managers as a class cannot possibly outperform the S&P 500 since, collectively, they are simply the S&P 500 with expenses. Unfortunately, there is no obvious answer to this argument. There is, though, a solution, and responsibility for its implementation falls on two parties. For active managers, the only solution is to be truly differentiated, trading indexation-based (uninformed) diversification for a focus on the specific areas of investment in which they can really add value – to be undiversified specialists. On the other hand, if the active manager abandons the trap of offering diversified portfolios, it is the client who will have to shoulder the burden of proper diversification by selecting from the variety of highly specialized, value-added managers.

How many times have we written about “semantic mis-investing”? That the description of an index or ETF does not necessarily mean that’s what you’re getting. Boring? Then, how about this: one of the largest ETFs in the land says the P/E of the holdings is 20x. But they exclude companies with negative P/Es, and almost entirely exclude companies with very high P/Es. So, the P/E isn’t really 20x, it’s more like 40x. Read inside, see how it’s done.

The average American, to go by the Federal Reserve statistics, does not have the necessary combination of savings or expected return, based on the record low interest rates and near-record high equity valuations, to accumulate sufficient retirement assets. (Neither do pension funds, for that matter.) Moreover, not only will ETFs or index-based investing not get them there, they’re likely to hinder them, because of the excessive distortions that have developed between the ETF labels – such as country representation, industry sector representation, and even statistical risk measures – and what’s ‘under the hood’. Investing effectively must now take place outside of the indexation sphere of focus.

A growing share of retail investment is made via automated asset allocation programs – robo-advisers. But how do these programs assess client needs and assemble recommended portfolios? Do potential fees earned by the provider factor into the proposal?

The trading volume for the largest index ETFs is truly astonishing, and is an order of magnitude greater than the turnover of the companies that comprise the underlying index. Why does this occur? One small part of the answer may lie in the emergence of robo-advisors.

The Beta Game Part I described one of the most important ETF statistical measures: beta. Beta is important, even though all it does is measure the historical day-to-day price variance of a stock or index fund versus the S&P 500, because ETFs are generally sold on the basis of both high performance AND low volatility. In fact, all the high-beta labeled funds we could find had, in aggregate, less than ½ of 1% of the assets of funds labeled low-volatility.

In Part II, we give some explanation–since it doesn’t otherwise really make sense–as to how, by the measure of beta, India or Peru has lower risk than the S&P 500, and as to how horribly wrong past reliance on historical correlations has gone. (It was Mark Twain who popularized the following phrase–attributed to Benjamin Disraeli but without definitive authorship: There are three kinds of lies: lies, damned lies, and statistics.)

We also offer a proof that some of the best investors of the past 30 years cannot survive in a beta-driven world. And as a bonus, we’re even giving away a classically good investment idea, because having the best kind of high beta (yes, there is good high beta) we know it would fail to even be considered as an ETF or fund product.

We have frequently observed that data without context is, at best, meaningless, and at worst, misleading. For many investors, beta (a statistical measure of the historical price risk of a stock or ETF relative to the broader market) has become among the most important factors in selecting an ETF. The implications for ETF providers can’t be ignored: demand for high beta ETFs is simply not there, so new ideas for high beta products are not likely to make it to market, while low beta products, no matter how irrational the beta may appear (e.g., does the Peru ETF really have the same beta as the S&P 500? Yes, it really does.), continue to gather assets. But if, as proposed in past commentaries, index constituent prices are driven by demand for ETFs rather than by the intrinsic value of the constituent companies themselves, what is the low beta of your ETF telling you?

Paradoxically, investing in emerging markets ETFs does not really provide all that much emerging market exposure. The Indian market, for example, is exceptionally broad, with thousands of securities that participate in the economy’s robust growth. However, the ETFs that purport to provide exposure to the Indian market turn out to hold the same roughly 50 large-cap companies, companies that are either truly global in nature (minimal Indian exposure) or in great demand and quite expensive . If one seeks exposure to the local Indian economy, the current generation of ETFs are not the way to achieve it.

In 2005, the S&P 500 Index methodology was changed to reflect float adjusted market capitalization. In this commentary, we consider the impact of this change on Index returns.

In this first “Under the Hood: What’s in Your Index?” series, we test a widely held assumption in many (if not most) investors’ allocation decisions. Most investors have some portion of their equity portfolio assigned to international stocks to diversify their exposure to U.S. stocks. But what if, through a major index like the S&P 500, you’re already allocated (or over-allocated) to non-U.S. economies?