Politics & Policy

Guess Your Weight

Is index-fund investing less risky than active investing?

Individual stock selection gets all the attention when it comes to investing, but the actual weighting decision — or the commitment of a specific percentage of a portfolio’s assets to an investment — may entail greater risk. A portfolio manager will determine a specific weighting in a portfolio depending on the confidence he has in the different companies he has to choose from. For active managers, there usually are constraints on initial portfolio weightings, industry weightings, and sector weightings. Portfolio managers will not only constrain their initial positions in securities, they will also sell or reduce individual holdings if those positions become too large. The purpose of these constraints is consistent with the basic tenets of modern portfolio theory: Keep the portfolio diversified.

Unfortunately, the weightings of securities, industries, or sectors within index funds are for the most part unconstrained. The only constraints an index fund might have come from the arbitrary decisions made by the creators of the index. Meanwhile, index-fund investing is perceived as less risky. Ironically, investors who blindly adhere to buying index funds can find themselves exposed to more risk than if their portfolios were actively managed using systematic diversification techniques.

Virtually all index funds are capitalization-weighted. When a particular stock or group of stocks perform extremely well they grow as a percent of the fund. There is no rule as to the sale of investments that grow to outsized positions. Herein lies the problem. Since many investors are attracted to the stock market during peak periods, they find themselves investing in index funds that are concentrated — the antithesis of modern portfolio theory.

For example, at year-end 2000, the Vanguard 500 index fund held 26 percent of assets in 12 securities out of 499. In other words, more than one quarter of the total portfolio value was in only 2.4 percent of the number of stocks in the portfolio. Investors who bought an S&P 500 index fund in late 2000 also found themselves heavily concentrated, in this case in a few large-cap stocks. This was only because those few large-caps were the stocks that appreciated dramatically in value, not because they were good investments.

The use of market capitalization to structure an index fund undermines the basic efficient market hypothesis and introduces weighting risk into indexed portfolios. So, many portfolios that are modeled after indexes are not passive in the sense of modern portfolio theory. For instance, the S&P 500, the leading index benchmark, is an actively managed portfolio utilizing a momentum-based strategy with no constraints on the size of industry, sector, or stock holding.

Of course, all this makes it easy for index portfolio managers, since there are no rebalancing decisions. But it means that the composition of the index-fund holdings of a portfolio has been delegated to the creators of the index.

When the media report on how well the market is doing they typically rely on weighted statistics. Similarly, index-fund managers manage money using weighted indices because it makes life easy: They don’t have to do any buying or selling of securities to keep a portfolio within certain constraints.

Managing an unweighted index, however, becomes a challenge depending on how frequently a portfolio is rebalanced. The investment committee at Standard and Poor’s recognized this problem and created an unweighted index of the S&P 500. Each quarter this index is rebalanced to offset the weighting impact of rising and falling stock prices. As such, this index gives new investors less exposure to market-weight risk than if they went into traditional index funds. Even better, the performance record of the S&P 500 unweighted index is substantially better than the weighted index.

Passive portfolio managers may penalize new clients who invest in the same assets as clients who have been invested in those assets for some time — and have benefited from substantial increases in the heaviest weighted securities. Hence, meaningful diversification must entail a mix of other indexed investments that allow for a portfolio that is less concentrated in large-capitalization securities.

Portfolios that are diversified by using different asset classes of index funds may be the best way to balance the risk-and-reward characteristics of weighted indices. Unfortunately for sizeable investors — like institutions and retirement plans — such strategies may be difficult to implement, whereas individual investors have the flexibility to make such weighting decisions.

– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and principal of Victoria Capital Management, Inc.

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