Beware

Beware of Index Funds - What Is It This Time?

Beware

There was a recent article published by Wintergreen Advisors calling index funds “a dangerous scam.” The two main claims against the use of index funds for investors dealt with having overly concentrated portfolios and some of the ethical issues involved in having an index fund being one of the biggest shareholders of a publicly traded company. Specifically, the authors stated, “the sad reality is that index funds have turned ordinary investors into the pawns in a game that undermines the integrity of American markets and imposes costs on society that don’t show up in index fund expense ratios. We believe that one consequence of this is that billions of dollars of value created by American companies are being diverted to a select few executives, while ordinary investors, distracted by ‘low fee’ hype are subjected to dangerous risk concentrations in their retirement portfolios.”

Let’s address these one at a time.

First, let’s address the bigger issue for investors, which is the claim that index funds leave investors in a positions of having highly concentrated portfolios. In the author’s own words, “the largest 25 securities by market value in the S&P 500 in 2014 represented more than 33% of the total return of the S&P 500, and the top 25 securities by performance contributed 55% of the index’s total return.” The proof that the authors provide as to why index funds has led to overly concentrated positions is the following diagram:


Source: www.valuewalk.com/2015/05/stock-index-funds-bad/

As you can see, the diagram highlights that although the best performing 25 stocks in the S&P 500 index only made up 5% of the index, they contributed to over 55% of the total return of the index in 2014. In other words, the movement of the S&P 500 Index is dictated by the performance of only a small subset of the index. The big winners in 2014 were primarily in the technology sector and included names such as Apple Inc. (NASDAQ:AAPL), Microsoft Corporation (NASDAQ:MSFT), Facebook Inc. (NASDAQ:FB), and Intel Corporation (NASDAQ:INTC).

The arithmetic is in fact true. If we looked at the top 25 holdings of the DFA US Large Company fund (TICKER: DFUSX), which is IFA’s choice in terms of gaining exposure to the largest companies in the United States, the cumulative percent of the overall portfolio is 30% (as of March 31, 2015), while the remaining 478 companies within the mutual fund make up the remaining 70%. Information Technology, as a whole, was the best performing sector of the S&P 500 Index and is in fact the largest component of the S&P 500, approximately 20% of the entire index. We do not have a particular issue for numerous reasons. First, this valuation is based off of the collective effort of market participants. These companies have proven to add the biggest value to investors in terms of the services and products that they offer. Names include Apple, Exxon Mobil, Johnson & Johnson, Bank of America, Disney, etc. It is just the reality that we live in. Second, the authors only looked at 2014 in terms of how a small subset contributed to the vast majority of the index’s returns. The technology sector ended up having a tremendous year, but it doesn’t necessarily mean that this trend is going continue. In general, if the biggest 25 companies all moved by the same amount in any particular year, then they as a whole would contribute almost 30% of the overall index’s return. Likewise, if all sectors moved by the same amount in any particular year, then the information technology sector would contribute approximately 20% of the overall return. The fact that there was short-term momentum in the information technology sector in 2014 could be nothing but random noise. There is nothing of statistical significance that we could draw from this one particular year. It also begs the question of, what is the alternative? If we are trying to get exposure to this segment of the overall market, what is a more effective way than in an index fund? We could broaden the base to maybe track the Russell 1000 Index, but it is not going to necessarily make a significant impact. Third, we do not define diversification as being solely the largest 500 stocks in the United States. Our index portfolios are exposed to over 12,000 publicly traded companies around the world, so that the top 25 companies are really just a drop in the bucket. As an example, in our IFA Index Portfolio 100, we have limited our exposure to this segment of the market to 12% of the overall portfolio. So although 25 stocks determined 55% of the overall S&P 500, they only determined approximately 7% of the entire performance of Portfolio 100 in 2014. This is what it means to be truly diversified. Lastly, the authors focused solely on the S&P 500 Index. If we were to take a look at the DFA US Small Cap Fund (TICKER: DFSTX), which seeks to gain exposure to the smallest 2,000 companies in the United States, the top 25 holdings only make up only 7% of the entire fund. So the authors cherry-picked the index to fit their argument.  It would be very hard to apply their conclusion to all index funds.

The second claim that the author’s made has to do with more of an ethical issue about CEO compensation. Specifically, they claimed that, “over the last five years, these stock index funds have cast their votes in support of executive equity compensation plans a mind-boggling 89% of the time, and voted against exec compensation plans less than 4% of the time. By the same token, these large index funds withheld or cast votes against directors a mere 4% of the time.” See the table below.


Source: www.valuewalk.com/2015/05/stock-index-funds-bad/

As investors, we should definitely be concerned about issues involved in corporate governance. For most investors, as shareholders of a publicly traded company the going concern of a company should be to maximize value. In other words, we want companies to maximize their value so that we can earn the greatest return for the risk that we take as shareholders. Governance issues arise when there are direct conflicts of interest between the managers (executives) of the company and the owners (equity owners). For example, when company executives decide to make a series of acquisitions to increase short-term performance, but leave the long- term concern of the company in serious questions. Although the overall value of the company may go up, which usually leads to increased compensation for executives, it might not be a great long-term strategic move for the company.

The decision by each mutual fund company to vote for certain measures and not others should come down to incentives. If the largest index fund companies such as Vanguard, Blackrock, and State Street believe that voting for increased CEO compensation is a positive incentive that will be in their investors’ favor, then they have a very rational explanation for their voting. I am more than sure that these mutual fund companies have investment committees that carefully consider each matter that comes across their tables.

At IFA, we work primarily with investment strategies offered by Dimensional Fund Advisors. Given the importance of corporate governance, Dimensional has clearly communicated their process for addressing this topic. As Joseph Chi, co-head of portfolio management at Dimensional, puts it, good corporate governance means “making sure that the management teams of the companies in which we invest have the right incentives to maximize shareholder wealth and among other things, to do the best possible job managing those businesses and not diverting income for their own use.” Dimensional’s approach to corporate governance includes a completely separate committee to work alongside the portfolio management department, proxy voting for their investors, talking directly to the management of the companies in which they invest, work alongside industry leaders in proxy research like ISS and Glass Lewis, and internal projects and research on what it means to have good corporate governance. Their key areas of focus are on anti-takeover provisions and related party transactions. In 2011, they voted 177,000 ballots on behalf of 182 portfolios, taking into the cost of proxy voting matters (especially overseas) and the benefit they are looking to capture for their investors.

Although there will be continuous jabs thrown at index funds, we believe that the benefits still outweigh the costs or potential threats that many critics throw at them. Holding an entire portfolio of index funds leads to a great amount of diversification that mitigates any type of concentration in any segment of the market. Corporate governance does matter and investors should be made aware of how their mutual fund companies are exercising their rights. Matching the right incentives with the right action plans will work in shareholder’s favor and we believe that the mutual fund company that we recommend always has our investors’ backs.