Index investing, in particular when it is directed to cap-weighted equity indices, is dumb investing. In fact when Warren Buffett recommended index investing to the masses, he made the point that it suits the “know-nothing investor”. That is, the investor who has no interest in understanding a business or valuing it.
If you have read this far, you are indeed a professional planner and index investing should therefore make no sense for you. It should make no sense for your clients either – they are relying on you and paying you to be a “know something” investor.
I have frequently used the following example to argue a number of positions, and this allegory also makes the case for smart active investing.
In 1919 Coca-Cola listed on the NYSE at US$40 per share. A year later the stock was trading at $19.50, the result of rising sugar prices and a perpetual contract Coca-Cola had with its bottlers to supply syrup for $1 per gallon. What would have happened if a single share of Coca-Cola was purchased in 1919 at $40 and held through all of the frightening subsequent economic and financial developments, including the subsequent decline to $19.50 in 1920, then through the great crash of 1929, the subsequent depression of the 1930s, World War II, a baby boom, dozens of other wars and skirmishes, an oil crisis, assassinations, the fall of the Berlin Wall, innumerable recessions, booms, busts and scandals, as well as a war in Vietnam, two in Iraq and the market crashes of 1974, 1987, 2000 and the global financial crisis?
Holding that single share, accepting all of the subsequent stock splits and reinvesting all dividends, would now equate to over 252,000 shares and the investment would have a market value, at $US40 per share, of over US$10 million.
It goes without saying that there would have been many periods and windows where the S&P500, the Russell 2000 and the Dow Jones indices outperformed the share price of Coca-Cola. Indeed, over the last two years the S&P500 has returned 35 per cent, while Coca-Cola has returned negative 5 per cent. And over the last five years, the S&P500 has returned more than 72 per cent, while Coca-Cola has returned 50 per cent.
But over the very long run – the period over which investing in a slice of a business makes perfect sense – sensible value investing in quality businesses cannot help but beat an index. The index is forced to be in both high and low-quality companies. A $40 investment in the S&P500 index in 1919 is now worth just $540,000, compared to the $10 million from one Coca Cola share.
Poor internal returns
Many commentators despair that the S&P/ASX 200 price index remains below its all-time high, some ten years later. And yet, without thinking about why this is the case, they advocate index investing.
The reason the index remains below its high despite an unprecedented amount of artificial, and temporary, support from low interest rates and quantitative easing is that the index is dominated by businesses generating poor returns on shareholders’ equity capital. Mediocre businesses generate mediocre returns on shareholders’ equity, and over time, share prices reflect this, ensuring small minority shareholders receive a return similar to that of a 100 per cent owner of the business.
As an example, Virgin Australia has required massive capital injections, holds $1.7 billion of debt and the share price is a quarter of its level of ten years ago. An investor in Virgin shares would have experienced an economic calamity over a decade proportional to that of the individual who owned the entire business. Investors in a large-cap Australian index fund have worn the consequences of this poor investment.
But airlines aren’t the exception. A cursory examination of share price performances for many so-called blue chips reveals many equally disappointing performances. Companies like AMP, NAB, Boral, Leightons, Lend Lease, BHP, Rio Tinto and Telstra might have paid dividends but their capital return has been disappointingly flat to negative over a number of years, even over a decade or more in some cases.
These blue chips make up the major cap-weighted stock indices and it is the blind buying of these diversified and cheap indices through index funds and ETFs that will ensure their investors receive similarly mediocre returns. This is due to the fact that over the long run, the market price of a stock will reflect the economic performance of the underlying business. Ipso facto, if you are buying a major stock market index, you aren’t investing at all, but speculating on share price increases from factors unrelated to the economic performance of the underlying businesses.
Don’t chase the index
The blind buying of mountains of stocks simply because they are in an index will drive mispricing that active managers can and will rely on to outperform the same index.
Unsurprisingly then, it isn’t true that most managers underperform their benchmarks after fees. In Australia, the vast majority of active small-cap managers beat their index. Their index is full of junior mining exploration companies that lose money or dilute, with frequent capital raisings, the ownership of the company for incumbent shareholders.
Simply exclude those companies from a portfolio, buy the rest, and hey presto, you’re beating the index over the long-run!
Poor quality companies however aren’t the exclusive domain of small-cap indices. There are rubbish companies in every index. Cap-weighted indices are constructed by aggregating the performance of companies based usually on their size or on what they do. They aren’t selected because they are highly profitable at what they do. And they aren’t selected because they are expected to produce strong returns over the long term for their investors.
Indices were originally designed as a way to measure the performance of the market, a single number to help determine whether the market was rising or falling, and to make comparisons over time. A cap-weighted index is not designed nor constructed with the intention of producing a solid long-term return for investors.
Invest for the long term? No thanks. At least not in those stocks or products. And that’s the thing to remember when “investing” in an index. Perhaps you aren’t investing at all.
