Denver Investments is proud of its legacy of active management, but we do understand that index funds can be prudent options for many investors – especially as complements to a core portfolio. The key caveat is that one must carefully monitor the funds, and the indices they purport to track, to ensure a specific fund is aligned with one’s investment objectives.
Many index investors, at least those with long-term time horizons, adopt an “autopilot” attitude toward their passive investments – “set it and forget it” seems to be the common refrain. Unfortunately, an index fund owned for more than a few quarters can run the risk of drifting away from an investor’s initial expectations, especially in more narrow or esoteric products. Index constituents frequently change, as do their weights in portfolios linked to that index, and a manager’s frequency of rebalancing (and related portfolio turnover) can have subtle and unintended effects on both risk and return. More importantly, an index provider (such as S&P, MSCI or Dow Jones) can change the methodology with which it constructs an index, effectively forcing the fund manager (such as Vanguard, State Street or BlackRock) to alter its associated investments. To us, these shifts run counter to that autopilot mindset that many associate with long-term investing in index funds.
Even a broad market index like the S&P 500 changes over time. Since the mid-1960’s, the S&P 500 has changed by an average of 20 companies, or 4% of the total index, each year. If one draws that level of change over five years, the nature of your investment will have changed by nearly 22%!
Different index providers employ their own methodologies when constructing their indices. These differences, while disclosed, may ultimately translate to indices with similar names having very different components – and thus returns. Take, for example, a passive investment in the emerging markets. Index provider FTSE classifies South Korea as a developed country, while MSCI classifies it within the emerging markets. So if you own the Vanguard FTSE Emerging Markets ETF (Ticker: VWO), your investment excludes South Korea, but if you own the iShares (Blackrock) MSCI Emerging Markets ETF (Ticker: EEM), you get 16% exposure to South Korea alongside your exposure to Brazil, Russia, India, China etc. In 2017, this difference in methodology made a meaningful nearly six percent difference in returns. Construction differences also exist around the definition of “small,” mid,” and “large” cap stocks, and the line between “value” and “growth” stocks can be even more obscure. Moreover, the stocks in these baskets shift back-and-forth all the time. Arcane methodologies can explain this situation, but it hardly makes for a simple, set-it-and-forget-it form of investing.
Confusion can also reign at the individual stock level; take AT&T as an example. One index provider considers it a telecommunications company, while another categorizes it as a tech company, and yet another lumps it into its utilities index. Clearly, whether one is invested in AT&T rests on one’s choice of a specific index fund or sector ETF. In short, similar names can give the false impression of similar index construction and leave it to Wall Street to slice-and-dice a myriad number of strategies in an effort to bring more products to market.
Here’s a little secret: your passively managed index fund is actively managed to some degree, in that a committee (of people, not machines!) can change the constituents of the index, forcing the associated ETFs or funds to blindly follow suit. A recent example involved the removal of real estate firms (largely, REITs) from their membership in the same sector that houses financial services firms. So, if you owned a financials-focused ETF, in 2016 you lost exposure to real estate companies by doing nothing. Talk about passive management! Another such change might be coming next year, as two index providers have proposed broadly shifting the membership of some companies that currently comprise the consumer discretionary, technology and telecommunications sectors, and placing many in a new “communications services” sector. While their proposals may make sense – to better reflect the significant economic and social changes brought on by new technologies (think Google, Facebook, Apple, Amazon, etc.) – the result for the passive investor will be a significant change in his or her risk and return exposures.
In the end, we remain strong believers in active management – in the classic sense for which we’ve served our clients for 60 years, but also in the way we evaluate, analyze and monitor fund investments, including those marketed as passive in nature. If you are evaluating your fund investments outside of our management, we are happy to assist you in that effort. Just remember, there is often more than meets the eye in an index fund.