After last week’s series about how I invest, a reader raised an excellent point with respect to passive investing. With all of the flows into passive strategies—pushing many stocks higher without regard to their individual merits—is it a safe time to go passive?
It’s a great point and one I agree with, as I discussed in a previous post on active versus passive investment management. This point deserves quite a bit more discussion. So, here we are.
What is passive investing?
The reality is that passive investing is actually more complicated than it seems on the surface. Let’s start with what I mean by passive, which is a systematic investment process on a preselected group of stocks. In practice, passive usually means index investing, where investors buy all of the stocks in an index in proportions that reflect that index. By doing so, the investment should match the index’s performance, less costs.
Taking a closer look, though, there are a number of decisions that need to be made. Which index and why? How is that index set up, and what does this mean for performance? Is that really what I want to do? What risks am I assuming with this index—and do I understand them?
The advantages of simple decision-making, lower costs, and index performance are well understood. The risks are less so, so let’s start with them.
The most obvious risk, at the moment, is that certain stocks and industries have had extremely strong runs. Depending on how your index is constructed, you might have more exposure to those companies and industries than you expect. For example, technology, as a percentage of the S&P 500, is now close to levels last seen in the year 2000. This is not necessarily a problem. But if you passively invest in the S&P 500, you are making a big bet on tech. You probably want to know that ahead of time.
How can that be? Because the S&P 500 is what is known as market-capitalization weighted. Companies with higher share counts and prices outweigh companies with, for example, larger sales. The argument for doing it this way is that the market cap reflects market valuations of companies, so more valuable companies should have more weight. In recent years, that means technology.
The problem is that this argument, while reasonable, is based on the idea that market prices are right over time, which is to say that the market is efficient. As we discussed last week, that is often not the case. It is also the problem our reader’s question addresses: do we really believe, as the market is now saying, that tech companies should be a major proportion of our investments? And if we choose passive strategies, aren’t we locking ourselves into that risk?
The answer is potentially but not necessarily. Passive is not the same as market-cap weighted, as you will notice if you go back to my definition. Market-cap weighting is just one way of building an index, and it is not necessarily the best.
Other passive strategies
Another way to build an index is to weight around something else, such as sales. In a sales-related index, companies with the highest sales would be weighted the most, even if their share prices and market caps were lower. Another strategy is to equally weight all companies in an index, regardless of size, and there are many more passive strategies.
Different weightings, different results
These different weightings can give very different results. Market-cap weighting does best in a bull market, where growth stocks—with high and rising prices and market caps—become a greater share of the index. As they keep rising, they pull the index up even more. That scenario is exactly what we have seen in recent years in the S&P 500. It is also exactly what has led to the risk we are currently discussing. Just as our portfolios have benefited from growth companies, we might well suffer if those companies stumble.
Other methods, including sales or equal weighting, have lower weights to the growth stocks and higher weightings to other companies that are not doing as well, price-wise. Those strategies are equally passive, and they don’t have that overweighting risk. But, of course, they have problems of their own. We will take a look at those tomorrow.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan. Forward-looking statements are based on our reasonable expectations and are not guaranteed. Diversification does not assure a profit or protect against loss in declining markets. There is no guarantee that any objective or goal will be achieved. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is not indicative of future results.