Here’s a provocative thought. Index investing is not an entirely passive investment management strategy. Passive investing is rife with implicit investment decisions, many of which investors unknowingly transfer to the invisible committees that manage such indexes.

Though a whole generation has grown up with the myth that indexes do not engage in stock picking, the fact is that all indexes regularly “buy and sell” individual stocks.

The Fallacy of Index Investing

Perhaps the best way to illustrate the stock picking nature of indexes is through a historical review of the composition of the S&P 500 index.

As most investors know, the S&P 500 is comprised of 500 companies spread across 11 industry sectors. Inclusion in the index requires a company to have a market cap of at least $13 billion (subject to change), generate positive earnings and be publicly traded. It accounts for about 80% of the value of the U.S. stock market.¹

Since 1995, the S&P 500 has had 715 additions and 711 deletions, or about 27 constituent additions or subtractions per year.²

While market valuations will always be a contributing factor to sector and stock weighting in the S&P 500, let’s take a look at the historical sector weightings that investors were exposed to over time due, in part, to these regular changes to the index over the years.

In 1980, the S&P 500 had a 25.4% weighting in energy and an 8.6% weighting in information technology. By 2019, the energy weighting fell to 4.0%, while information technology jumped to 22.1%.³

This evolving sector exposure points to another implicit investment decision and potential risk—sector concentration. Passive index investors in 1980 were highly concentrated in a sector that subsequently lagged for the next several decades. Today, the index is highly weighted to technology names, the wisdom of which only the future can answer.

According to a study by Wharton professor Jeremy Siegel, the return of the original S&P 500 firms, unaltered, outperformed the returns of the continually updated S&P 500 and did so with lower risk during the period of 1957-2003.⁴

In other words, passive investors have portfolios that are continually “buying and selling” individual stocks based on a qualifying index algorithm, rather than on the relative merits of the company’s stock valuation or future business prospects. And, as the research suggests, these changes are not always beneficial to the investor’s portfolio.

This discussion is not necessarily an argument against passive inventing; indeed, index investing has been very rewarding to many investors. However, investors should be aware that their passively-managed investments are in fact making buy and sell decisions regularly.

Sources:

1. https://insight.factset.com/through-the-looking-glass-predicting-sp-500-constituent-changes
2. https://www.spglobal.com/spdji/en/documents/research/research-what-happened-to-the-index-effect.pdf
3. https://www.dws.com/globalassets/merill-lynch/pdfs/cio_view_sp_500_sector_composition.pdf
4. https://rodneywhitecenter.wharton.upenn.edu/wp-content/uploads/2014/04/0429.pdf

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