Steve TeSelle, CFA, CFP ™
June 2003
The financial pages are full of advice about investing, and particularly
about suggestions for investing in indexes. It may be helpful to explore exactly
what indexes are and how they work.
The most commonly used benchmark for equity investing is Standard & Poors 500 Index. Several companies, including Vanguard, have developed low-cost mutual funds that replicate the index, and so offer investors an ability to invest in the index.
Standard & Poors (S&P) is a division of McGraw-Hill Companies. S&P has a committee that decides which stocks will be added to and deleted from the index. Stocks of companies are added based upon criteria such as the number of shares that trade in the market and the financial strength of the company. Stocks can be deleted due to the shares of the company no longer meeting the criteria, or due to mergers or bankruptcies.
The index is market-cap weighted, which means that the market value of a company's shares (shares outstanding times stock price) determines its weight in the index. The higher the market value of a company, the greater its index weight. For example, General Electric currently has a market value of $294 Billion; the entire index has a market value of $8.3 Trillion. So General Electric comprises 3.5% of the index.
The index tends to be diversified across industry sectors. But this isn't always so. At the beginning of 2000, more than 40% of the index consisted of technology companies. Currently, in mid-2003, technology companies comprise about 16% of the index. Financial companies, currently the largest industry weight in the index, comprise about 20% of the S&P 500.
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These days, indexes abound. Standard & Poors has large-cap, mid-cap, and small-cap indexes. They have also created an equal-cap weighted index for the S&P 500. Dow Jones, of course, has the venerable and oft-cited Dow Jones Industrial Index. The Frank Russell Company has, among others, the Russell 2000, which is commonly used as a benchmark for small-cap investing. Wilshire has the Wilshire 5000, which encompasses a whole bunch of US stocks (about 5000) and is used by Vanguard and other mutual fund companies as a benchmark for the entire US market. Morgan Stanley has the Morgan Stanley Country Indexes (MSCI) for investing in foreign equities. And Lehman Brothers is known for its bond indexes, in particular the Lehman Brothers Aggregate Bond Index, which is a benchmark for intermediate-term bonds issued by the US Treasury, US companies, and US Agencies (such as Fannie Mae).
You should always understand the index in which you invest. For example, some of the foreign-country indexes are dominated by a handful of companies. If you buy the Switzerland Index, you are essentially buying drug and food stocks, in particular Nestle, Novartis, and Ciba-Geigy.
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Buying an index is often a cost-effective, simple way to invest in a particular market. Several mutual fund companies offer index-based mutual funds with low fees. Exchange-traded funds (ETF), which are essentially stocks of indexes rather than companies, are another alternative.
So if you want to set an asset allocation of 70% stocks and 30% bonds, you could buy a mutual fund or ETF that tracks the S&P 500 or the Wilshire 5000 for stocks, and the Lehman Brothers Aggregate Bond Index for bonds. Then you can set a regular time interval to check the account and complete any transactions to keep the asset allocation as originally set.
You can get even fancier, by dividing the market in to more pieces. For example,
you could have a large-cap, mid-cap, small-cap, and international index funds
for your stock allocation, and an intermediate-term index, a high-yield (junk
bond) index, and foreign bond index for your bond allocation. Just remember,
the more you slice and dice the market, the more effort you have to put into
keeping track of and maintaining your investments.
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Taxes are an issue for mutual funds because funds have to pass on tax liability to their investors. This was a big problem in the late 1990s, when funds sold stocks that had appreciated throughout the decade. Even if investors kept their money in the fund, the investors owed tax on the pass-through of the gains. This may not be a big issue for a couple of years, because the market has fallen so much that many mutual funds have no gains to pass on, and probably losses to carry forward. Also, index funds tend to be more tax friendly to investors because they buy and sell less often than active managers. A bad scenario for index fund investors would be if the index appreciated, and many investors then redeemed their shares. In that case, investors who remain in the fund could be left with a hefty tax bill, even though they haven't sold their shares.
The other problem with index investing is that your portfolio can get out of whack. For example, if several stocks double or triple in value, while many others stagnate (this is what happened in 1999), investors can end up with large positions in industries or individual stocks. S&P's stance, rightly so, is that they just create the index, and disclose how they do it. How anyone decides to use the index is up to that person.
Finally, index investing provides a little less flexibility than holding individual
stocks. In a taxable account, if you buy an index and the index appreciates,
if you decide to rebalance or if you need to sell some of your portfolio to
meet other needs, you'll owe tax on your gains. With individual stock holdings,
you may be able to sell a holding that hasn't appreciated much, and so owe little
or no tax, even if your overall portfolio has appreciated.
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Dorato competes against the S&P 500 Index. You may have noticed that the weaknesses of index investing that I listed are longer than the strengths. If I didn't believe that, I wouldn't be doing what I'm doing.
But of course, the proof should be in the results. I suggest you compare a firm's results against whatever benchmark it uses. I strongly recommend that you make sure that the results are calculated in compliance with the performance standards set by the Association for Investment Management and Research (AIMR). These folks try to ensure that firms use consistent methods to calculate returns so that investors have at least a fighting chance at evaluating and comparing firms. The investing world is full of reasonable-sounding ideas. But in the end, the proof is in the performance.
"I don't know, Phil. A submerging markets index doesn't sound so hot to me."
© Dorato Capital Management, LLC. All rights reserved.
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