Excellence

There Are Indexes, and There Are Indexes

Excellence

Last Thursday (10/17/2013), we saw something that we don’t see very often—The S&P 500 Index gained 0.7% while the Dow Jones Industrial Average (the Dow) remained essentially flat. As its name implies, the S&P 500 consists of 500 large companies that are representative of the industries in the U.S. economy. The Dow has a similar goal but only utilizes 30 companies rather than 500. Mathematically speaking, the Dow can be thought of as a subset of the S&P 500. One important difference between the two is that while the components of the S&P 500 are weighted according to their market capitalization, the components of the Dow are weighted according to their share price, adjusted for stock splits. Weighting by market capitalization makes it far easier to construct an index fund based on the S&P 500, and this may explain why the Dow never really caught on as an index for that purpose, aside from the fact that it has only 30 companies, less than 1% of the publicly traded companies in the U.S. stock market.

While the S&P 500 is far and away the most popular index with over $5 trillion1 benchmarked to it, we should not lose sight of the fact that it is not a rules-based index. Its constituents are decided by a committee that arbitrarily decides which companies are in or out. If the S&P 500 were a mutual fund, we would consider it an active fund, but with very low turnover. Nevertheless, the committee does follow guidelines that results in keeping the S&P 500 well within the large blend category (although it does a small amount of mid-cap exposure). The large blend fund that IFA advises for non-taxable accounts (the DFA U.S. Large Company Fund) very closely tracks the S&P 500, but it has one important distinction—it is not required to buy and sell companies on the same day that they are added to or deleted from the index. This forced trading by index funds can potentially be a drag on the returns received by index fund investors.

The most popular index for small capitalization companies is the Russell 2,000 index. This index consists of the 2,000 smallest companies among the 3,000 largest publicly traded companies, and thus it is easily predictable which companies will be added to or deleted from the index. This has been quite costly for investors in Russell 2000 Index funds who, according to an article2 published in the Financial Analysts Journal, lose over 2% per year due to the reconstitution effect. In other words, there is a high cost for insistence on a low tracking error.

Dimensional Fund Advisors takes a unique approach to their passively managed funds, most of which were designed by Eugene Fama, a 2013 Nobel Laureate in economics. You can think of them as private index funds in that DFA does not share the list of which stocks qualify for its funds with any outside parties. Furthermore, DFA does not consider itself compelled to buy every single company that meets the rules of construction of the fund. This allows the fund shareholders to benefit from being a provider of liquidity rather than a demander of it. An additional advantage of DFA’s trading strategy is its awareness of momentum, the tendency of securities that have outperformed (or underperformed) the market over a three- to twelve-month period to continue to outperform (or underperform) the market. As far as we are concerned, the underlying investment process is far more important than the short-term results, and it is our opinion that DFA has a very sound process, and the results shown in the table below illustrate the long-term benefits of that process.

The world of indexing has indeed come a long way since 1976, when the only index fund available was Vanguard’s S&P 500 Index fund. To navigate the daunting array of choices (over 1,700 at last count), it is quite helpful (some would say necessary) to have the assistance of an investment advisor who specializes in index funds. If you would like to explore the possibility of working with a fiduciary for wealth, please take IFA’s Risk Capacity Survey or call us at 888-643-3133

 


1http://us.spindices.com/indices/equity/sp-500

2Cai, Jie and Todd Houge (2008). "Long-Term Impact of Russell 2000 Index Rebalancing." Financial Analysts Journal, Vol. 64, No. 4 (July/August): 76-91.