Passive investing usually involves trying to replicate the performance of some broad market index. The S&P 500 is one of the most common stock indices. If one chooses the passive approach, one should know the characteristics of the underlying investment. For example:
- How well does the index represent the desired asset population?
- What is the criteria for inclusion in the index (i.e. the specific characteristics of the stocks desired in the index universe)?
- How are the stocks weighted in the index?
- What is the computational method used in the index (i.e. does the index represent only the price change in the included stocks or does it include dividends (total return))?
Let’s look at index weighting. Stock in the index can usually be weighted in the following manner:
- Price Weighted- Each stock is weighted by its absolute price. A stock priced at $50 has twice as much weight in the index as a $25 stock. The index construction is relatively simple; however, there is obviously a price bias.
- Value (Market Capitalization) Weighted- Each stock is weighted according to the company’s market capitalization (the company’s price per share times the number of shares). The bias here is toward large capitalization companies. This bias can result in a less diversified portfolio concentrated in a relatively few companies. The S&P 500 is composed of the 500 US stocks with the largest market capitalization; however, the top 10 (2%) companies comprise about 17% of the index.
- Equal Weighted- Each stock is weighted equally in the index. In this case, small companies have the same weight as large companies.
The dominant passive approach is indexing. This approach assumes the financial markets are fairly priced with few opportunities for mispricing. The turnover in the portfolio is low (changing only when the index composition changes) and the internal expenses are generally low. The most popular investment vehicles are index mutual funds and exchange traded funds (ETFs).
Active investing assumes there are strategies which can be used to yield a higher return the market index. Such strategies usually assume: 1) holding more of the higher return companies in the index, or 2) holding less of the lower return companies in the indices. This active strategy can include segmenting the market (growth stocks, value stocks, large cap stocks, small cap stocks, international stocks, etc.) and using complimentary investing strategies (selling stock short, using options, derivatives, etc.).
Which Is Best?
Much has been written and numerous academic studies have been conducted to answer that question. There have been periods when each method has been the better performer. Consider the “lost decade” in stocks. On January 3, 2000, the S&P 500 index was approximately 1468; on December 29, 2009 it was approximately 1114. However, in between it reached a low of 681 (March, 2009) and a high of 1565 (October, 2007). Therefore, indexing for that decade would have lost money. Active management could have yielded gains in the decade.
A more reasonable approach might be temper maximized investment returns with the client’s risk tolerance and the return necessary to reach the client’s goals. We, at Paragon Financial Advisors, will help our clients identify and realize this balance. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.