The risk of actively managing index investing


I own index funds, so I refuse active management. Hmm, no. On the contrary, if you hold index funds, you practice active management like everyone else. The main difference is that you follow the herd by allowing either a committee that put together your index fund or the market itself to decide your active bets on your portfolio. The herd mentality works great when the market is up. But it can be an absolute killer when it comes to managing your risk over time.

You make active bets when indexing the market. Ironically, nowhere is this more the case than at the epicenter of index investing with the S&P 500.

How can I make active bets holding the S&P 500 Index? Consider the following.

A big bet on technology. By holding the S&P 500 index (SPY), I decide to allocate around 24%, or almost a quarter of my investment, to the information technology sector (XLK). And that doesn’t include the additional 4% that was previously in the technology sector, but transferred to the newly created communications sector (XLC) a few years ago.

So what? Only twice in the last three decades has a sector accounted for more than 20% of the S&P 500 index. The technology sector in 1999 and 2000, and the financial sector from 2002 to 2006. The technology sector has then lost -83% of its value from peak to trough and was still nearly -80% lower eight years later. The financial sector then fell -83% from peak to trough and was even lower than its peak in early 2007 just a year ago.

Technology from 2015 to present is the third example of a sector making up more than 20% of the S&P 500, and technology today is well over 20%, arguably approaching 30%.

Will tech drop more than -80% once the next stock market deluge begins? Probably not. But given historical precedent and from a risk management perspective, I’m not sure I want to automatically throw 25-30 cents on every dollar in the industry, either just because the market and/or a creative committee clues tells me.

OKAY. So perhaps the index investor opts for an equal-weighted S&P 500 ETF (RSP) instead. This reduces my exposure to the technology sector to just over 14%. Indeed. But even though it is just another index product, an active management decision is made with the move.

A big bet on some big tech names. By owning the S&P 500, my big dose of technology is also very concentrated. Nearly 10% of my money is allocated to just two tech names Apple (AAPL) and Microsoft (MSFT). And another 10% slug goes to just four other names from Amazon (AMZN) (i.e. the most hyped company in the world – amazingly my local grocery stores are still open!), Facebook (FB ), Berkshire Hathaway (NYSE: BRK.A) (BRK.B) and Google (GOOG) (NASDAQ:GOOGL)three of which are also adjacent tech or tech.

So what? These companies have been impressive performers for years. But expecting them to continue to be the top performers in the years to come just assumes that not only will technology continue to win, but that these specific companies will continue to represent an increasing percentage of the market at a compounding rate. The only problem is that it would be historically unprecedented. For example, it’s rare for a single company in the S&P 500 to make up more than 4% of the index, but today we have two in Apple and Microsoft, both approaching 5%.

By holding the S&P 500 today, investors are betting that the already unprecedented will continue to become even more unprecedented. These are bets I seek not to make in risk management. Because if and when these stocks start to falter, what has been an extraordinary tailwind will turn into a frustrating headwind.

A desire to absorb the full impact of the next recession. After what is now the second longest period of economic expansion and bull market in history, the S&P 500 fell more than -50% from March 2000 to October 2002. And the stock market fell almost -60% from October 2007 to March 2009. These, ladies and gentlemen, were your last two bear markets. And they both happened at the time of very accommodative fiscal and monetary policies for the financial markets.

Today, we are living through the longest period of economic expansion and bull market in history. How long it lasts, no one knows. But what we do know is that economic growth has been chronically slow and the bull market has been remarkably euphoric (a dubious combination, by the way) thanks in large part to supercalifragilisticexpialidocious fiscal and monetary policy that has supported financial markets at all costs and in many ways at the expense of the masses.

Don’t you think stocks could drop -50% to -60% or more in the next bear market? Recall that the S&P 500 index was down -20% in the blink of an eye in Q4 2018 before the Fed’s extraordinary about-face. What will happen the next time the Fed has already squandered its political ammunition and stock buybacks have stopped? Who will then be the marginal buyer of the shares? And at what level on the S&P 500? (Hint: much, much, much lower than today – if retail and institutional investors have been selling on the net since 666.79 in 2009, they won’t suddenly start buying right away when the S&P 500 starts to drop after the buyout craze is finally over – it’s going to take a long time)

By owning the S&P 500, you accept the willingness to potentially be down -50% to -60% or more at some point in the future.

Do you plan to hold on during the downdraft? Much easier said than done (it is difficult for even the most steadfast investors to look at the value of a portfolio that was once in the millions and is now in the hundreds of thousands and continues to drop day after day, day after day…) .

Planning to hang on until the next bounce to new heights? Stock prices always go up over time, right? Be careful, because the political support that saved our stock market bacon the last two times may not be there the third time around. Ask a post-crisis stock market investor from China, Italy, Spain or Brazil what that feels like. Or an investor from Japan in the late 1980s. Or an investor in the United States from the late 1920s. Remember, there was a time when house prices always went up over time.

As an investor, do you just want to actively bet on fully accepting this potential downside risk? From a risk control perspective, I prefer not to.

Indexing US large-cap stocks is a sideshow anyway. Do not mistake yourself. I am not devaluing index investing. In fact, I use it a lot in my own portfolio management. But it’s important to recognize it for what it really is, which is an active management decision to just take whatever portfolio bets the market gives you. And the S&P 500 is not on my menu choices that I actively use today, because I don’t like some of the bets I’m given from a risk management perspective.

Here’s the thing. Whether I use indexing or active management to invest in the large cap segment of the US stock market is a secondary or tertiary consideration anyway. Because if I really want to effectively manage risk over time, I’m less focused on how I manage risk within a specific asset class like stocks and instead I’m much more focused on how I manage risk across my entire asset allocation which includes equities, yield, commodities, precious metals, currencies, bonds, alternatives and cash.

It is important to remember that the stock market is just one of many different, uncorrelated asset classes that are readily available to investors today. And the large-cap segment of the US stock market, represented by the S&P 500 Index, is just one of many, albeit important, categories within this single equity asset class.

So, for investors looking to optimize their risk-adjusted returns over time, stocks are a prop. Instead, the portfolio’s broad asset allocation is the main event. And whether I’m using active or passive underlying products to build this asset allocation, this process is more efficient through full active management, however you cut it.

Disclosure: This article is for information only. Investing involves risk, including loss of capital. Gerring Capital Partners and Global Macro Research make no express or implied warranties as to the performance or outcome of any investment or projection made. There can be no assurance that the objectives of the strategies discussed by Gerring Capital Partners and Global Macro Research will be achieved.


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