36. Index Games

I recently received a Consumer Reports publication including an article titled "New twists in index funds". The twist they present is not that new. What was new to me was the degree of deception in a publication I usually trust.

What is it all about?

Index funds, like their name, track an index of stocks. A reliable index for the US economy is the S&P 500, which tracks the performance of the biggest 500 companies in the US. It is market-cap weighted - in other words, it corresponds to the total value of the biggest 500 companies. Naturally, movement in bigger companies matter more than smaller companies: If ExxonMobile (the biggest component of the index) increases 10% in value, the index will move by a couple of percentage points. If the smallest company in the index moves by 10%, the index will badge very little. This makes sense to me - the economy of the US is more ExxonMobile, IBM and Apple than AK Steel Holding and Monster Worldwide (whose market cap is less than 1% of the the top components).

But, apparently, CR thinks otherwise:

Equal-weighted S&P 500 is a recent invention: take all 500 companies in the index, and weigh them equally. ExxonMobile is now as important as AK Steel Holding. Apple fortunes are as significant as Monster Worldwide.

Does it make any sense? Nope. But look at the graph! The blue line is higher than the red line! Must be a good thing, not so?

Kind of. As long as you bought before 2008 and sold now. I'm surprised that CR relies on such meager data to draw conclusions on the benefit of equal weighting. In fact, if you look at the graph carefully you'll see that between 2003 and 2008 the two indexes had identical performance, and in the last year the traditional cap-weighted S&P 500 is slightly better. The Equal-weighted version had the upper hand in two years - not a significant period of time for any long-term investor. And it can be easily explained by the observation that the modified index is heavily tilted towards small-cap companies. And yes, in some years small-cap will give better results than large-cap, in the same way that in some years large-cap is better than small-cap, banks are better/worse than technology, foreign markets are better/worse than domestic markets, etc. You can never predict these movements in advance, and a couple of good years for small-cap stocks don't say that they're superior. In fact, long-term research shows that although small-cap stocks, over the long run, have higher return than large-cap, they also carry a much higher risk. I would advice against anchoring anyone's portfolio on small-caps.

The solution - in my opinion - is to continue to diversify and invest in everything, from large cap to small cap, through more varied indexes such as the Wilshire 5000. Or invest in the S&P cap-weighted 500, if you prefer the increased stability of large-caps. But don't fall pray to short-term fads and tricks like the equal weight fashion. Besides paying higher fees for the novelty, you're not going to gain much.

Next week: yet another way to build an index, crazier than the two mentioned above, and yet used in the most popular index of all. Stay tuned!