How Evidence-Based Indexing Works
The strategy uses common sense, data, and financial science to boost performance.
In the hallowed halls of academia, noted professors at the top business schools are teaching entire semesters on the benefits of investment strategies using passive indexes instead actively managed mutual funds or picking stocks.
As of 2017, more than $4.5 trillion has flowed into passive index funds and exchange-traded funds. What is passive investing, why are trillions of dollars flowing to this strategy, and more importantly is there a better way to invest?
To fully understand passive investing, it is helpful to understand active investing. Here investment managers (or investors doing it on their own) try to outperform the overall stock market or a specific part of the market using strategies such as fundamental and technical stock picking or market timing.
Passive investing involves buying the entire market or entire sectors of the market to capture the overall return of that market or sector. This is usually done by investing in an index through a fund or ETF. The largest example of this is the Standard & Poor's 500, which is a stock market index made up of the 500 largest companies publicly traded on the New York Stock Exchange and Nasdaq. There are passive market indexes for virtually any market or sector – small-cap, global, international, technology, emerging markets and socially responsible to name just a few.
The data is compelling. Various studies have shown that the average investor using actively managing strategies have significantly underperformed the S&P 500 on a consistent basis. A recent study by S&P Dow Jones showed that more than 80 percent of active managers failed to beat the underlying index.
Is there a better way still? Academic studies show that there is, and more and more investors are putting their investment dollars to work in strategies implementing these academic studies.
Most indexes, such as the S&P 500, are weighted by market cap. The 500 stocks are not equally weighted as you might think but are weighted by the size, or market capitalization of the stock.
Apple, the largest stock in the S&P 500 with a market cap of $879 billion, is 3.79 percent of the S&P 500. The top 10 stocks make up 20 percent of the S&P 500. The top 25 stocks make up 35 percent of the S&P 500.
Union Pacific Corp., the 50th largest of 500, is only 0.44 percent. TripAdvisor, the 498th, is 0.02 percent.
What is obvious about passive index investing that uses market capitalization to weight the indexes (and most do) is that the performance is heavily weighted on the top 25 stocks and the rest of the 475 have much less influence on how well the index does.
In plain terms, using the S&P 500 in 2018 as our basis, if Apple, Facebook, Amazon.com, Microsoft Corp., JPMorgan Chase & Co., Alphabet, Johnson & Johnson and Exxon Mobil Corp. are doing well, so are you. And the opposite holds true.
It was academia that gave us the efficient markets hypothesis on which passive investment strategies are based. It was academia who understood some of the inherent problems with the bedrock of passive investing-weighting the indexes by market size.
Winners of a Nobel Prize for economics, professors Eugene Fama and Ken French developed the Fama-French 3 Factor Model in 1992. Additional research led to an additional factor being added. It is easy to get bogged down in economic theory and never get to the important conclusion of this work as it applies to the modern individual investor. In short, the Fama-French model shows that markets drive returns, not stock picking or market timing; investing in the market outperforms active management; and in weighting the market or sectors of the market, using four factors outperforms one factor (weighting by market cap) over time.
The four factors are:
- Market capitalization outperforms individual stock picking or timing.
- Small stocks outperform large stocks.
- Value stocks outperform growth stocks.
- More profitable companies outperform less profitable companies.
Data shows that small stocks outperformed, or in academic terms added a premium of 2.4 percent, while value stocks added a premium of 3.6 percent and profitable firms added a premium of 4.7 percent.
Once presented, it makes common sense. It is now called evidence-based investing. At the core of the strategy is that investing in the market using rules supported by data and financial science provided the investor a premium in performance.
Again, common sense.
A word of caution is in order. Fama-French models have morphed into a new investing strategy that many categorize as "smart-beta" funds using factors such as momentum, dividends, stock buybacks and a holy host of others. Remember, the basis of evidence-based investing is rules supported by data and financial science. Also, at the core is efficiency and low cost. The further a strategy strays from those tenets the more the benefits can be lost.
What is most important is the need to invest. Active management, stock picking, and market timing have been around for many decades and will be used decades more. History, theory, and results show passive investing to be a very successful investment strategy. With a strong body of research and over a decade of results, evidence-based investing strategies offer a proven alternative to active and passive investing and at best a low-cost, efficient investment strategy that can be a core of your financial and investment planning.
U.S. News, March 15, 2018