Rethinking Passive: Why own the Trash and the Treasure

According to wikipedia.com, a stock market index is a measurement of the value of a section of the stock market. For decades, the only stock index was the Dow Jones Industrial Average (Dow). From it’s origins in 1896, the Dow has been figured in the same fashion. The Dow tracks the performance of 30 US stocks with a weighting toward the companies with higher prices. In the course of its history, the Dow has changed constituents regularly to keep up with the times. It’s important to note that the original intent of the Dow was to give investors a general idea of the direction of the market over periods of time.

In 1957, the Standard and Poor’s 500 Index (S&P 500) was introduced as a market capitalization weighted stock index. Market capitalization is the total value of a company’s outstanding stock. Very simply, the S&P 500 Index is constructed of large US companies that list on either the new York Stock Exchange or the NASDAQ stock exchange. Again, the original intent of the S&P 500 was to give investors a sense of the direction of the broad market over time.

Indexes morph

We can thank (or not in my case) John Bogle, founder of the Vanguard funds for creating the first index fund in December 1975. Bogle’s premise and rationale for launching the fund was that most investment managers did not beat the returns of the S&P 500. Therefore, if one could invest in the market as a whole they would do better at a lower cost. Such was the birth of index funds. As well, this was the point at which indexes morphed from being a tool to see direction of markets to a benchmark to be compared against.

In the early 1980s, computing horsepower ramped up and the number of index funds steadily increased. The real explosion in the number of index funds came with the creation of exchange-traded funds (ETFs) which made it easier to create investable products for any index someone could dream up.

Times have changed

The marketing machine that is the financial services industry has done a great job of wrongly conditioning investors to use indexes as benchmarks. In addition, they’ve used their marketing machine to convince investors that its better to own the whole market than the cream of the crop. Where else in life do you just go for average?

Prior to the popularity of index benchmarking, both professional and non-professional investors designed portfolios around personal needs. Today, with the inundation of index related news and marketing, many investors have turned their focus away from personal needs to a ‘keeping up with the Joneses’ mentality.

Consider a quote from Tom Dorsey of the research and asset management firm Dorsey, Wright and Associates.

“Comparison in the financial arena is the main reason clients have trouble patiently sitting on their hands., letting whatever process they are comfortable with work for them. They get waylaid by some comparison along the way and lose their focus. If you tell a client tat they made 12% on their account, they are very pleased. If you subsequently inform them that ‘everyone else’ made 14%, you have made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy. Money in motion creates fees and commissions. The creation of more and more benchmarks and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.”

Tom Dorsey – Dorsey, Wright & Associates

I look at indexes as they were meant to be used which is as a general guide to market direction. I’m of the mind that investors should focus their attention on a target return that will help them achieve their goals. If that rate is 8% per year and they strive for 12% they are taking on more risk. By taking more risk than necessary their goals may turn out further away than one intended when something inevitably goes wrong in the markets.

It’s important to remember that indexes are ‘dumb’ in the sense that they are fully invested at all times in both profitable and unprofitable companies. Further, they are market cap weighted which can skew returns in meaningful ways. In the end, investing is about balancing risk and reward attitudes and not about keeping up with the Joneses. If one’s investing focus is shifted to a single index’s performance versus balancing their personal risk and reward attitudes, it is likely that their investing goals are in jeopardy.

Our knocks against indexes

Below is a consolidated, brief list of why we are not index fans:

  • You own the trash with the treasure. If you’re investing in a broad market or sector index with more than 30 holdings, it’s likely you have trash with your treasure.
  • Most indexes are market cap weighted which can significantly skew returns.
  • From a market viability standpoint, indexes can be blamed for supporting unprofitable companies. Consider that by being in and index, like the S&P 500, a company will have demand for shares regardless of how well the company achieves it’s goals. So, indirectly, index investing is propping up unhealthy companies.

Owning index funds should be a last resort if you have no interest in managing your money.

Final thoughts in images

The charts below show the 10-year return history of owning ETFs that track industry indexes versus the returns of the cream of the crop stocks in each category. Sadly, the marketing of ETFs and index funds has been to ask why take the risk of owning a handful of stocks compared to owning the whole index or sector.  The charts below are a great piece of evidence against buying the indexes.

Rather, find the good companies with moats. These charts breaks down the Russell 1,000 index (1,000 largest US companies) into sectors as of 12/31/2022. It also shows returns data for the S&P 500 and the ETFs that track each sector as a whole (yellow). There are a few notes to keep in mind.

  • I did remove any company younger than 10 years (about 180 stocks).
  • As well, the communications services sector only appeared as a stand alone in the last 5 years.  Prior to that, many companies in the communications area were part of technology and other sectors.
  • Each sector is sorted by highest 10-year return.
  • Not every company listed here is a moat stock. But, quite a few are moat stocks.
  • Click images for larger view

The point here is that you would be better off owning a few of the cream of the crop companies versus the ETFs or the sector indexes. The question is how to find those cream of the crop companies?

Well, that is my raison d’être. Through my screening process we put together portfolios of quality companies sans the trash found inside the indexes.

This website and associated newsletter along with its content/links are not financial advice. Nothing in this newsletter is an investment recommendation. All content is created for entertainment, educational, or informational purposes only. My strong buy, accumulate, hold, reduce or sell opinions are exactly that – opinions. Be sure to do your own research for your own particular circumstances or higher a professional advisor.

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