March 23, 2005, 8:33 a.m.
The Hidden Risks of Index Investing
It’s not as passive as you may think.

Index, or passive, investing is touted as a low-cost, low-risk, prudent way to design your portfolio of financial assets. The alternative approach — active investing — is looked upon as a risky and sometimes unrewarding strategy. But the implied belief that a passive strategy offers investors — especially professional fiduciaries — a free pass to prudent portfolio management should be questioned on the grounds that there are other risks associated with passive investing that could exceed the risks associated with active management.

One of the leading proponents of index investing is Vanguard Group, a major mutual fund company with billions of dollars invested in many different types of index funds. A recent Vanguard publication defines an index as “a group of securities chosen to represent an entire market or a portion of the market.” For example, the Dow Jones Industrial Average and the S&P 500 are two popular indices used to represent the U.S. stock market. These indices contain 30 and 500 stocks, respectively, so neither index comes close to full representation of the U.S. stock market, which includes well over 5,000 stocks.

Among the accepted index investment strategies, a full replication strategy is the simplest. In this strategy, a portfolio is constructed by investing in all of the securities in an index with the same weightings as the index. A sampling strategy, on the other hand, involves assembling a portfolio by using a sampling of the securities in an index. To implement this approach, quantitative techniques are used to ensure that a portfolio has characteristics that are similar to an index. A sampling strategy is normally used to replicate an index that contains a large number of securities, or when the components of an index are illiquid. A sampling strategy also helps reduce the costs of portfolio maintenance.

By the mid-1970s, modern portfolio theory became the bedrock of investment management theory as institutional investors and mutual fund companies began to endorse the idea of passive investing by utilizing indexes (such as the S&P 500) to create equity portfolios that mimicked the selected indexes. By the early 21st century, over $1.1 trillion was invested in index funds, with publications on investment risk claiming that plan sponsors and institutional investors were not meeting their fiduciary responsibilities if they did not invest in index funds.

Marketing materials promulgated by Vanguard compare the long-term costs of index funds with those of actively managed portfolios and conclude that the higher expenses of active portfolios substantially lower long-term returns. Yet, when one looks under the hoods of these investment strategies, the index engine looks very different from the passive engine.

As an example, the most popular index used in the creation of passive equity investments is the S&P 500. Rather than a well-diversified passive market portfolio, the index is managed by a committee. According to Standard and Poor’s,

The S&P 500 is maintained by the S&P Index Committee, a team of S&P economists and index analysts, who meet on a regular basis. The goal of the Index Committee is to ensure that the S&P 500 remains a leading indicator of U.S. equities, reflecting the risk and return characteristics of the broader large-cap universe on an on-going basis.”

When companies in the index are merged into other companies, or when companies shrink in size to where they are no longer big enough to qualify for the index, they are eliminated (the equivalent of being sold from a portfolio) and other upcoming companies take their place (the equivalent of being purchased into a portfolio). These changes in the portfolio often result in short-term price volatility when stocks going out of the index have to be sold from indexed portfolios and stocks going into the index have to be bought in order for the indexed portfolio to retain index characteristics.

By the very nature of these additions and deletions, the indexed portfolio is not a legitimate passive index. Rather, there is an investment style for the index that is momentum based (i.e., more money is invested in stocks with growing market value and less in companies with shrinking market value). On the one hand, an indexed portfolio that has no cash flows won’t make new investment decisions unless there is a change in the stocks that comprise the index. On the other hand, an index fund that experiences cash inflows will allocate funds differently than the allocations of previous investors. Since the components of an index are market weighted, or weighted based on the value of the stocks in the index multiplied by the number of shares outstanding, new index investors are required to invest more in larger-market-capitalization companies and less in smaller-capitalization companies.

So, the portfolios of new index investors will be heavily weighted in large-cap stocks. This phenomenon goes against modern portfolio theory that says markets are efficient and that all information influencing stocks is known. In one sense, this artificial demand can have a self-fulfilling effect in that large inflows into indexed funds will increase the demand for larger-cap companies, thus increasing their price and forcing an increase in portfolio weighting. This theory implies that a legitimate passive portfolio should be equally weighted, not market-weighted.

To sum up, the so-called passive index, at least in the case of the S&P 500, is really an actively managed portfolio of securities that utilizes a momentum-based investment style and is market-weighted, indicating that the index structure will require new investors to invest more in those stocks that have gone up more in value and less in those that have declined in value.

— Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc.

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