Whenever someone argues for passive investing, very likely he or she will mention that the S&P 500 had beaten most actively managed funds over ten years or longer.
S&P 500 is often the poster child for passive investing, or more specifically, index investing.
Well, because it has performed very well. Possibly the best performing index all time.
Even recently, the S&P 500’s recovery from the COVID health crisis outpaced all the other world indices.
It is truly the role model for indices.
What is an index?
An index represents the stock market, or a segment of the market with a single price, typically calculated from the weighted arithmetic mean of a selection of stocks.
Think of it as a test report score that measures a student’s mastery over an academic subject.
An index is also a market indicator, informing the public about investors sentiments.
An index also serves as a benchmark for comparing returns between funds.
Why is the S&P 500 having such a successful performance?
Selection criteria of the S&P 500
Think of indexing as enrolling into a university.
All stocks within that market or markets will be subjected to some eligibility criteria.
Some selection criteria are strictly rule-based, i.e. you to be of a specified minimum size of a certain percentile. An example of such indices is the Russell indices.
Some university admissions require additional interviews or extracurricular activities or other stuff besides meeting the necessary criteria. Even if you are of a certain percentile, you need to meet additional requirements. It introduces an element of subjectivity.
Similarly, constructing the S&P 500 is both an art and a science.
A specific committee within the S&P does the selection process of which stocks goes into the S&P 500. The standard requirements are that the company must be domiciled in the U.S., have minimum liquidity and free float shares etc.
Also, there is a profitability requirement for companies to be included in the index. The committee looks at the company’s fundamentals. It must have positive revenues for the recent cycle, and it has to be profitable for the last four quarters.
Is the S&P 500 considered active then?
Not necessarily. Even though there is a committee actively screening and selecting the stocks that go into the index, the intention is slightly different from actively managed funds.
For the S&P 500 committee, they intend to screen for profitable companies that serve as a good representation of the U.S. stock market performance.
Whereas for active fund managers, they filter and pick stocks to beat the S&P 500, if it was their benchmark.
So, it is not active in the traditional investing sense because they are not actively picking stocks for beating market returns. Neither is it a completely passive index because there are human decisions (often subjective) involved in selecting the constituents of the index.
An Index For The World’s Largest Economy
Whether the U.S. will continue to retain its economic superpower status is uncertain. But today, it is the undisputed biggest economy in the world with its growth outpacing Europe, Japan and other developed countries. Probably only China may overtake it one day in the future.
Much of the S&P 500 underlying success is due to the companies in the U.S. It boasts of the likes of Microsoft, Apple, Google, Amazon and Facebook.
There was a famous example of Warren Buffett’s million-dollar bet pitting a low-cost index fund against hedge funds. Mr Seides accepted the challenge, and after ten years, we all knew how it went – the S&P 500 index fund trounced the five hand-picked hedge funds.
Before we can celebrate this victory and start evangelizing passive investing to our active friends, let us take a more in-depth look into this bet.
Not an apples-to-apples comparison
To be fair to Mr Seides, he took up this challenge at the worst possible time, and it was not an apples-to-apples comparison.
Mr Seides published his side of the story: Why I Lost My Bet With Warren Buffett. He alluded that high hedge fund fees were not his downfall – it was mainly global diversification that hurt his returns. He added that the MSCI All Country World Index had performed in line with the hedge funds during that period.
The S&P 500 is a strategy that is concentrated in the largest U.S.-listed stocks. Compared to more diversified, low-cost passive investments, the S&P 500 is biased toward U.S. stocks relative to global stocks and large companies relative to small ones. These two bets generated anomalously strong relative performance in this period. It was global diversification that hurt hedge fund returns more than fees.Mr Seides in Why I Lost My Bet With Warren Buffett
I am not saying that hedge funds are better than low-cost index funds. And I am not saying that high fees do not matter – they do.
What I am saying here is that the S&P 500 had generated abnormally better returns than the other world indices.
Because the S&P 500 had the top best companies in the world, and they happened to be in the U.S.
The U.S is so massive that it constitutes 60% of the MSCI world index.
And if you look at the Dow Jones Industrial Average and the S&P 500, their performances are quite similar. But if you add the tech-heavy Nasdaq into the mix, you start to see the real reason behind the excellent returns – the big tech companies.
As Warren Buffett had recently said, believe in the magic of America because we will prevail, or something along those lines. Indeed, its stellar performance is nothing short of magical.
The S&P 500 is a shining example of it.
The S&P 500 is also not a completely passive index – it is curated by a small committee.
So, should we abandon our domestic market and flock to America? Only if we want to speculate and hope that Americans can make America great again.
So, should we also abandon passive investing in favour of active investing?
I still think it is best to diversify across all countries because you never know which country will emerge as the next superpower.
And it is still prudent to keep costs low by choosing passive investing over active investing in the long run.
But if you want to bet on a country index, bet on the S&P 500, not the Straits Times Index.