Index Mania

Index Mania!

Most of the time there are many diverse actors independently participating in the stock market. As a result pricing is usually pretty rational. However there are times when the market loses its diversity causing the pricing mechanism to breakdown. Think back to 1999 as internet related stocks were soaring beyond any reasonable valuation measure. John Chambers of Cisco stated that Cisco was going to be the first trillion dollar market capitalization company. Not only did it never advance near that value, soon after Chambers uttered those words the tech bubble burst and Cisco lost over 80% of its value. In hindsight, it’s clear the bubble prices occurred because only momentum investors were trading the stock –rational pricing had broken down because there was no longer diversity in the market.

While nowhere near the same extreme a similar phenomenon is occurring with index funds. First a quick primer: Indexes have been defined as a “measurement of the value of a section of the stock market computed from the prices of selected stocks (typically a weighted average).” For instance, the S&P 500 is an index of generally 500 large companies selected by the Standard and Poor’s company. The S&P 500 index holdings and resulting performance is determined by the size of the companies in the index. The largest company has the largest representative ownership, the second largest company has the second largest representative ownership and on down the line. Therefore your performance is determined more by the larger companies than the smaller ones. So there is generally a difference in the performance of the average stock in the S&P 500 index and the index itself.

Recent outperformance of large US stocks has been a boon for most indexers, but like all cycles they end and another begins. According to the research firm The Leuthold Group, active management is most likely to beat the index when the following conditions hold: small- and mid-capitalization stocks beat large, US stocks lag the rest of the world, and value stocks beat growth. None of those conditions were in play the last few years, explaining the weaker performance for active managers. But since the big market reversal in February almost all of these conditions now look favorable for active. Money is pouring into passive strategies due to especially strong performance recently just as the underlying conditions are starting to favor active managers. Dare we say the typical “buy high, sell low” behavior. True trend reversals tend to be long term in nature so we are quite optimistic that active strategies will perform better going forward.

Staying invested in the market is a necessity if an investor wants to achieve the returns of the market. This is easier said than done as volatility can be intense at times. While it is a valid argument that many investors would be successful if they placed their money in an index and left it alone, in reality, investors do not do this. Studies consistently show that investors make the wrong changes when the markets are in the throes of fear and/or greed. Think of the financial crisis (fear) and the tech bubble (greed). Professional guidance can help investors from panicking and help investors maintain their discipline. Systematically rebalancing portfolios, a characteristic of many active strategies, is less an exercise in timing and more of a tool to discipline investors into selling high and buying low.

Volatility will likely be a prominent feature of the market going forward which will challenge investors in an un-managed index strategy. Active strategies that allocates into less-correlated and lower risk assets may help investors hold on during volatile periods, and importantly, be around for the next upturn.

Research provider, Strategas, has also independently made this down market/active management correlation observation. In the Chart above, the highlighted box shows strong active management years during recent negative performing years for the S&P 500 Index. Further it is noted that five of the last six years have seen high single or double digit returns in the market, the most difficult environment for active management to distinguish themselves.7