Love Indexes – Hate the Index

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

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