September 2023: Voltaire and the Irony of Passive Index Investing
The French Enlightenment philosopher, writer, historian Voltaire once wrote: “The Holy Roman Empire was neither holy, nor Roman, nor an empire.”
Adapting one of history’s pithier jibes to the realm of financial advice, we think the so-called passive index is most often neither passive nor an index, and it is most certainly not investing.
Investors should take heed.
Let’s start with the passive piece of the puzzle. The secret cabal — aka the “committee of market professionals” — that oversees the S&P indices is, according to its own material, active in that there are numerous examples of the committee overriding its own rules, in each case to the benefit of investors in the index. In the case of AIG during the 2008-09 financial crisis, S&P claims its decision to override the rules by dropping AIG “would have sent the markets tumbling yet again.” So, effectively, the committee is claiming it helped prevent a worsening of the financial crisis. Sure…
Not an index
Next is the notion that S&P is an index. Per its stated objectives, the index is designed to be “an accurate picture of the stock market.” As of July 31, 2023, approximately 32% of the weight in the S&P 500 was attributable to 10 stocks. Does that paint an accurate picture? We would argue no.
Similarly, the index’s concentration in a single sector is a persistent problem. Its decision to move companies like Alphabet and Meta from the technology sector to the communications services sector in late 2017 seemed like nothing more than an effort to present a façade of adequate diversification. At the time the move was made, technology composed approximately 26% of the index. It now stands at a larger weight (28%) even when excluding Alphabet and Meta; including those two brings the weight close to 35%. We acknowledge that the stock market does not to approximate the economy, necessarily. However, at a weighting roughly three times that of technology’s contribution to GDP, we contend that the lack of risk control at the sector level is another failure of the S&P to construct an appropriate index.
S&P attempts to exculpate itself from the responsibility of investing by stating, “The Committee is not trying to pick stocks to beat the market.” Fair enough. However, we need look no further than its decision to include Tesla in late 2020 as evidence that maybe, just maybe, it should at least try to avoid obvious asymmetrical, risky bets. Did the company technically meet its criteria, especially vis-à-vis positive earnings? Yes, albeit barely, having earned around $0.47 per share over the trailing 12 months. That put its P/E ratio around 95x when the committee decided to make the addition. By Dec. 18, when it was added, the P/E was 116x. I get that the S&P was not trying to pick stocks to beat the market, but making the largest ever addition to the index, and a top-10 holding at the time, no less, at that valuation is reckless. As of August 17, 2023, the S&P has declined almost 4% since Tesla’s inclusion, while Tesla has declined approximately 30%. Apartment Investment and Management Company, AIV, the company Tesla replaced, is up a little over 2% for this period.
S&P also “helps” investors who are more interested in a specific style of investing, e.g., growth or value, construct portfolios. It has a growth and a value index, both of which, like the S&P 500 itself, are subject to rules regarding their construction. While it is beyond the scope of our discussion here to delve into the specifics of how these indexes are constructed, suffice it to say that this approach to identifying growth versus value stocks would also fail our definition of investing. To use one example, the value index, which was rebalanced in December 2022, has a lower weight in the energy sector (less than 2%) than the parent S&P 500 (around 5%) despite the notable quirk of energy being unequivocally the least expensive sector in the index.
Use common sense
Assets allocated to passive strategies have grown rapidly since the financial crisis, fueled by government regulation, performance chasing — which is a product of the Fed’s rapidly ending largesse — and sloth on the part of retail investors and many financial advisors.
Chasing the recent strong performance of an index like the S&P 500 while ignoring the massive risks associated with such an approach defies reason and common sense. We believe constructing portfolios with true diversification and considering risks are important components of a thoughtful, long-term investment approach. However, as Voltaire also stated, “common sense is not so common.”