LUTZ BUSINESS INSIGHTS
Love Indexes – Hate the Index
JUSTIN VOSSEN, INVESTMENT ADVISER & PRINCIPAL
Studies have shown that over longer time periods actively managed funds are outperformed by their respective index benchmarks. In one such recent study, Standard and Poor’s¹ released that more than 79% of US Large-Cap funds are outperformed by their respective index over a five-year time period. It’s numbers like these that continue to show the benefits of passively managed fund selection over their actively managed peers.
While the benefits of index funds can be many, it’s important to note that all indexes aren’t created equal. For example, the most notable and talked about index in the world, the Dow Jones Industrials, may be do the worst job of representing what it is supposed to reflect.
Most media types quote the Dow Jones Industrial Average as the proxy for the United States stock market. Quoted on newscasts and by professionals who should know better, the Dow index is what many quote when they talk about stock market performance. Rarely do you hear anyone say, “Did you hear the Russell 3000 fell 12 points today?”
However, the Russell 3,000 measures the performance of 3,000 publically held US companies based on total market capitalization. The Russell 3,000 represents approximately 98% of the capitalization of the US equity market. Market capitalization is better defined as the “net worth” or “value” of the equity market. The Russell 3,000 is a very good proxy of the broad US “stock market”.
However, the Dow-our most common proxy, only contains 30 large US based stocks. They are chosen by the S&P Dow Jones indices and are intended to represent the breadth of the American market. How could 30 companies represent the breadth of the US stock market when there are roughly 15,000 different publically traded companies in the US alone?
It’s also a price weighted index. What does this mean? It skews the weighting of the index to the companies with the higher price. For example General Electric, which trades around $25, carries about 1/8 of the weighting than IBM does trading around $175. Further complicating, is that GE has a market capitalization (worth) of $250 billion, which is about 37% higher than IBM. So essentially, the bigger company carries far less weight in the index than smaller company. Now, one can understand why Berkshire Hathaway is not in the Dow Jones!
So, why is the Dow Jones Industrial Average still the unofficial proxy of the market? It is the second oldest index and was first calculated in May of 1896 (the Dow Jones Transportation Average is the oldest). The price weighting of the index made it easy to calculate by hand, and probably most importantly was calculated by the same company that published the Wall Street Journal! The Wall Street Journal had profit motives to promote the index. Even back then, the media was influencing perception in the stock market!
We now have computers that can calculate indexes by the millisecond, and thus the proliferation of different index offerings abound. You now have indexes from: Russell, Dow, S&P, Wilshire, CRSP, Barclays, MSCI and many others. Which one is the right one? Ultimately, for your portfolio, it really doesn’t matter. What matters is that your portfolio contains the proper amount of diversification in the asset classes in which you desire exposure. What index you benchmark it to matters less. We’d probably just recommend avoiding the Dow Jones Industrial Average!
¹ Standard & Poors SPIVA® Scorecard Mid-Year 2013
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.
ABOUT THE AUTHOR
JUSTIN VOSSEN, CFP®, NAPFA + INVESTMENT ADVISER, PRINCIPAL
Justin Vossen is an Investment Adviser and Principal at Lutz Financial. With 21+ years of relevant experience, he specializes in providing wealth management and financial planning services for high net-worth families, business owners in transition, endowments and foundations. He lives in Omaha, NE, with his wife Nicole, and children Max and Kate.
AREAS OF FOCUS
- Investment Advisory Services
- Comprehensive Financial Planning
- Business Owner Planning & Succession
- High Net Worth Families
AFFILIATIONS AND CREDENTIALS
- CERTIFIED FINANCIAL PLANNER™
- National Association of Personal Financial Advisors, Member
- Financial Planning Association, Member
- BSBA in Economics and Finance, Creighton University, Omaha, NE
- St. Augustine Indian Mission, Board Member
- Nebraska Elementary and Secondary School Finance Authority, Board Member
- St. Patrick's Church, Trustee
- Mount Michael Booster Club Board
- Lutz Gives Back, Committee Chair
- March of Dimes Nebraska, Past Board Member
- A 100-Year Bet Gone Bad
- Personal Finances: Focusing on What You Can Control
- Planning for College Pragmatically
- Remaining Calm When Uncertainty Surrounds Us
- Am I Ready to Retire? Finding Your Sweet Spot
- 5 Retirement Strategies for Small Business Owners
- Outsmarting the Ivy League?
- An Investor's Year-End Wrap Up & Tax Prep
- Nobody Knows Anything
- Add "Brexit" to the Long List of Uncertainty
- Financial Planning for College Grads
- Fight or Flight - Lesson Learned
- Social Security: The New Rules
- Putting Volatility in Context
- The Asian and European Fronts
- Bubble Looming or a Bubble Popped
- Re-Emerging Markets?
- A Market Perspective
- Timing is Not Everything
- "Yellen" at the Fed
- Mind What Matters...Focus Efforts On What You Can Control
- What to do With a Financial Windfall
- Love Indexes - Hate the Indexes
- Do I Own a Market?
- A Practical Primer On Volatility
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