Investing and sports can be similar in that good performance can be driven by a handful of superstar shares or players.
In 2015, for example, the US S&P 500 index had a total return of 1.4 per cent. But if you took away just four stocks – Facebook, Amazon, Netflix and Google – the index would have suffered a loss of almost 3 per cent.*
When making a choice, as a sports fan or an investor, you need to fully understand what you are choosing.
So how does a share ‘make the team’ to be included in an index?
In this article, we look at common myths about benchmark investing versus active investing, and discuss what you need to know about both in order to make choices about what’s right for you.
What is a benchmark index?
A benchmark index is a group of stocks that is intended to represent the value of a given market. For example, the Russell 1000 Index, the S&P 500 Index and the Dow Jones Industrial Average (DJIA) are all widely quoted benchmarks for US stocks, even though the Russell index contains about 1,000 stocks and the DJIA contains just 30.
Nearly all benchmark indexes are weighted by market capitalisation (cap). Market cap is calculated by multiplying a company’s share price by the number of its outstanding shares. Companies with the largest market cap have the largest weight and therefore have the most influence over the index’s overall performance. Companies with smaller market caps have less influence because they represent a smaller portion of the index.
Do companies deserve higher weightings based solely on market cap?
Since market cap weighting is largely determined by share price, it makes sense to use benchmark indices as a compass for recent market sentiment. Historical performance data from various indexes is also extremely valuable in research, but what about as an indicator of future performance? That is what investors are most concerned about.
We don’t believe that total market cap alone defines the future potential of any investment. Bear in mind that there are many reasons why shares go up (pushing market cap up), and some have nothing to do with the fundamentals of the company.
Consider what happened to Facebook in December 2013.
When the company joined the S&P 500 its stock surged by 4 per cent. Passive index investors were obligated to pay a higher price for Facebook even though nothing changed regarding its business model. Or the Dotcom bubble of 1999-2000, when technology companies were all the rage and became notoriously overvalued. They carried more weight in benchmark indices, but this had nothing to do with business success. Since then, we’ve experienced bubbles in real estate and commodities as investors flocked to these sectors and pushed up prices.
How will you choose your portfolio ‘players’?
Investing in benchmark indices can result in something you want to avoid—buying stocks when prices and emotions are high. Because the most expensive issues can dominate market capitalisation-weighted indexes, you may wind up buying more shares of overvalued companies while leaving potentially much better deals on the table.
On the other hand, active fund managers look at company fundamentals to make investment decisions, and ‘smart beta’ funds track indexes that are weighted by factors other than market cap. While different managers will be more skilled than others, they all seek tomorrow’s opportunities, not yesterday’s.
Investment success is far more likely when you truly understand what you own and why you own it. Active, smart beta and traditional passive strategies can all play a role in a well-constructed portfolio, but you have to know why you’re choosing these players to join your team.
Talk to your OBT financial planner about any questions you may have on your portfolio allocation on 5462 2277.
Rodney Turner and OBT Financial Group are Authorised Representatives of Lonsdale Financial Group Ltd ABN 76 006 637 225 | AFSL 246934.
This is general advice only and does not take into account your financial circumstances, needs and objectives. Before making any decision based on this document, you should assess your own circumstances or seek advice from a financial planner and seek tax advice from a registered tax agent. Information is current at the date of issue and may change. This information and certain references, where indicated, are taken from sources believed to be accurate and correct. To the extent permitted by the Law, Lonsdale, its representatives, officers and employees accept no liability for any person that relies upon the information contained herein. Information is current at the date of issue and may change.
* FactSet Research Systems, Inc. Note that Google is now known as Alphabet.