The Case Against Indexing

January 01, 1999

Birinyi Associates studied the index fund phenomenon and found a lot to criticize in something so hugely successful. Birinyi argues the result of the growth of such funds has been distortion: distortion of the benchmarking process for money managers, distortion in the valuation of whole classes of equities, and distortion of trading in the market itself. Birinyi thinks active money managers are very unwise if they underestimate the market power of passively managed funds.

Indexing continues to be a salient, if not prominent, feature of the investment landscape. We expect this to continue for a number of reasons:

• Historically, active managers have not been delivering satisfactory results compared to index funds.

• The proliferation of indexes and the articulation of styles provide convenient vehicles for the investor who wants value stocks but whose value manager might feel business pressures to temporarily abandon those names.

• Index managers are proving to be proficient marketers.

• And critically for active managers, individuals are finding these funds to be a viable alternative. One need only examine the growth of the Vanguard S&P 500 Index to see the public's attitude toward passive investing.

We think that indexing will continue to grow and become even more prominent and pronounced.

Interestingly, the market seems to be of the same opinion. If we compare the growth in fund assets to fund companies' prices and the growth in overall stock prices, it appears the market is less than sanguine about the outlook for active managers.

Active managers themselves provide one of the strongest and most compelling arguments for the continuation and growth of indexing by not providing any persuasive or especially articulate arguments against the approach. It was both disappointing and surprising to read a large number of articles about the issue and find that the overwhelming argument against passive approaches was emotional and not intellectual:

• ... [index] funds are a 'cop-out' and search for mediocrity.

• ... they are downright un-American.

• ... They provide no downside in a falling market.

There is an abundance of other equally unconvincing arguments. In one instance, an institutional client asked major firms for their views. Among the reasons cited: Index funds could not generate soft dollars and index funds held more stock hence their custodian fees were higher. As suggested, active managers are not providing a viable counter argument.

There seems to be a recurring hope among active managers that indexing has run its course, that active managers will again prevail and that there will be some reversion to the mean. Thus strategists looking for an idea or audience seem to find both when they write that active management will again prevail.

We disagree. Estimates regarding the amount of passively managed assets are too often that - estimates - with little or no empirical evidence. But we conclude that about $1 trillion is indexed to the S&P500 or - put another way - over 10% of the value of the 500 is in index funds.

We should also note that state and local funds continue to be major index fund investors. They have large cash flow, their manager constraints are stringent, and their staffs are generally small, so index funds are a simple, direct vehicle to participate in the equity market. In an admittedly quick perusal we found no decreases in indexing among these plans and some examples of increased exposure.

Since 1990, state and local retirement plans have added $251 billion to their equity assets. We believe that the majority of these funds is indexed. Hence the suggestion that indexing has peaked is a hope but not a reality.

Active managers - defending their turf - also argue that the familiar graph showing that fewer and fewer funds are outperforming is unfair. They contend that their universe is more than 500 stocks and that a broader benchmark should be employed. But even if we use the Wilshire 5000, active results remain inadequate.

Lastly, active managers find hope in the notion that they will prove their mettle in down markets. But again the data are not supportive:

• In 1994 the S&Phad a total return of 1.3% while mutual funds lost 1.4%.

• In the fourth quarter of 1997 during the Asian crises, managed funds did not do well. So while active managers continue to argue that their cash, experience, flexibility and skill will prevail in tough times, the evidence does not support that conclusion.

This should not necessarily be taken, however, as an indication that the S&P 500, for instance, will continue to outperform professionally managed portfolios. We believe that the 1973-1975 period will prove to have been peculiar in its turmoil and discontinuity...

Fortunately, such disasters are relatively infrequent. During the 'free-fall' experienced during such periods and the explosive, broad scale rebounding in security values which follows such pronounced declines, the application of fundamental research and analysis to search out long-term investment values is not as useful as it is during more normal periods.

We believe that the continuation of indexing has critical ramifications for all members of the investment community, not only on both sides of the Street, but also for others involved in the industry (journalists, consultants and so forth).

THE WRONG MEASURE

• To measure all mutual funds against the S&Pis misleading and absurd.

Sector funds, funds with specific criteria (social or green funds, contrary funds or whatever) have different objectives. Using the 500 as a bar for all funds is just plain wrong. Ahealth-care fund which is so marketed should not be considered satisfactory or outstanding if it goes up 30% in a year the 500 gains 25% but health care and drug stocks double.

• Our biggest objection is that aggregate fund results are usually unweighted and so do not reflect money. The growth of mutual funds (in both number and amount) has been well documented.

But not all funds are created equal and not all funds are equal in the critical issue of assets. To argue that a $100 million fund's 5% gain offsets the 5% loss on a $10 billion fund verges on foolish.

To better understand how well funds are really doing we took the assets of the fifty largest funds for the last eight years and determined their results on a weighted basis using dollars. These fifty funds represent nearly half of the assets of all growth and growth-income mutual funds.

We compared their results to the S&P 500 and calculated how much more money they would have made (or lost) had they been in line with it. In 1990 Fidelity Magellan ended the year with $12.326 billion and was down 4.51%, which meant its shareholders, in the aggregate, lost $555.89 million. Had Magellan matched (down 3.12%), the decline in assets would have been $384.56 million. Hence the excess decline was $171.3 million. (The next year the fund had an excess gain of $2,031 million).

Aggregating the fifty funds for 1990, there was an excess loss of $2.089 billion. But 38% of that loss occurred because of one fund. Seven of the top fifty showed positive returns; 14 bested the S&P's returns.

But even within this universe, the concept of weighted returns shows that active managers have done better than many commentators suggest. In 1990, one fund, ranked 44th, was down 12.66% and had an excess loss of $66.75 million. But that was more than offset by the 13th largest fund's 2.39% gain or plus $116.69 million.

In the eight years we examined, the top fifty outperformed two of the years with three years being very close. For the entire span, the total results show that funds have not kept pace, but the results are not as dismal, not as disappointing, and not as consistently poor as many would claim.

And even in the 'bad' years, the loss was usually a function of several funds. (Unfortunately, in good years it was likewise a result of a minority of the funds).

THE WRONG CONCENTRATION

The majority of indexed assets are concentrated in the same, familiar names, which are - mostly because of index funds - overvalued by most fundamental criteria. Major stocks in the S&P500 are also likely to be in the Russell 1,000, in the OEX, in the Schwab 1,000 and so forth. (They are often also in less conspicuous quantitative portfolios such as the Dogs of the Dow). As a result, these stocks have continuous support which boosts their prices as well as their valuations.

We find it curious that many investors who contend that the market is efficient, that the market has historically rich fundamentals and who opt for passive investing are, in fact, buying the most expensive segment of the market and putting up to 50% of their assets in stocks with high multiples and extended fundamentals.

The first half of 1998 was exceptional in a number of respects (mega deals, disparity between continents such as Asia - Europe), with the gain in the market being one of the biggest surprises. But the US market saw its gains limited in scope to selective issues. This is partially reflected in the results of the various indices.

And technicians have noted that the advance-decline line or the new high-low list likewise reflects a deteriorating situation (a conclusion we do not share). The dichotomy and strength of large names is primarily a function of indexing.

To illustrate the difference we might note that in the first half of 1998, the S&P added $1.28 trillion in value. Over 50 percent of that value was a function of 17 stocks.

 Passive accounts must buy those stocks but they need not necessarily buy the smallest stocks. In lesser names where liquidity and float might be considerations, funds might model, sample, optimize, use futures or otherwise 'substitute' components. But it is an absolute necessity for index funds to have a fully replicated position in Microsoft (to select a name not entirely at random). And given the gains in that stock, they must take those positions immediately upon any addition in assets.

The focus on these favored names is also a function of individuals' buying stock directly. In fact, our money flows show that the ratio of non-block to block money has changed markedly in the last several years. Currently non-block money is buying stock at two times blocks'buying. In early 1997 non-block buying was half that of blocks.

While this too has widened the gap between the haves and the have nots, the divergence within the market has been primarily a function of index funds.

This further means that index funds are buying the most expensive, the most irrational, and least compelling fundamental issues in the market. And they will continue to do so. If we look at the valuations of these favored stocks it is not only disconcerting: It is scary.

And the valuations of these stocks call to mind another group of favored names of the nifty-fifty of the 1970's.

THE WRONG COMPONENTS

The S&P500 is a confederation of names that has evolved with no rationale or reason in its development. It is merely a group of 500 stocks as opposed to the Russell 1,000, which is the 1,000 largest US corporations. Hence, S&Pindexers reflect an arbitrary group of stocks.

We would be more favorably disposed to the 500 if it were perhaps reflective of the US economy. But we examined the composition of the two and found that the differences between the economy and the index are pronounced.

Furthermore, S&P did not historically place any emphasis or rationale or reason on this property. It was not so much a business as a convenience. One example of this was the first detailed Business Week story on the 1982 bull market: As shown, in a table, one of the largest S&Plaggards was Masonite. The stock was not, however, down 60% but had recently spun off Timber Realization Corp.

When index funds were in their embryonic state, the Equity Market Analysis group at Salomon Brothers [which Birinyi left to form Birinyi Associates] was intimately involved in trading and servicing the trading arm of Salomon as well as the funds themselves. To our knowledge we were the first group to unilaterally maintain the 500. We published a quarterly handbook listing weights, groups, performance, and distribution of $100 million into the index. In this effort we regularly found mistakes and oversights in S&P's calculations.

To some extent, the EMAgroup was more concerned about the index than was S&P as we, on occasion, would ask how a certain situation was to be treated. And the response 'what would you do' was hardly reassuring and reflected the fact that it was not [at least not then] a priority of S&P.

INVESTMENT EFFECTS OF INDEX SUCCESS

Index funds currently approach $1 trillion and hence support and reward managements who are judged primarily on stock price and not on business objectives. It would also suggest that inclusion among the favored is more beneficial to management than increased sales, better margins, and other historical criteria.

Early in the development of these funds, various criteria were used to eliminate companies, which did not meet certain standards. We have occasionally seen index funds with 487 or 495 stocks. In any case many managements are rewarded on the basis of stock price appreciation when they have done virtually nothing to effect those price gains.

In smaller companies, significant stakes are often held by insiders, founding families, foundations or the like. Then and now, indexing reduces available shares. Ironically the parties most affected are probably index funds that may not be able to buy the required shares at some market price. Many of the stocks are, therefore, subject to periods of extreme volatility, unusual price and volume characteristics and unique trading patterns. As a result, indexing reduces the active investor's ability to anticipate market flux.

We suggested earlier that it was disappointing to see the lack of articulation and rationale for active management. But indexers are not exempt from criticism either. It was also disappointing or annoying that passive managers too often have an attitude of smugness bordering on arrogance. In fact, when they go beyond the absolute index, they stumble as well. In one study, eight enhanced funds did not live up to expectations: five were underperformers and the three that did as advertised beat the market, but only by small margins.

And Vanguard's Quantitative portfolio is another fund with a gimmick (eliminate stocks with very high or low multiples, sluggish earnings, etc.). While the goal is to outperform by 100 to 150 basis points, only once in the first eight years was the goal achieved.

A more disturbing case was an article where John Bogle took active managers to task. He argued that active managers were skewed toward smaller companies and that they did not own enough large stocks.

But absolute comparisons should not be the criteria for ownership. What really matters are weightings relative to the S&P.

Indexing or passive management and the growth of institutional assets will, unfortunately, make it more difficult for large investors to outperform and almost impossible to outperform by a large margin.

Historically, active managers have been able to produce better than benchmark results for three reasons:

• By buying stocks not in the index

• By overweighting key stocks

• By underweighting stocks

With the growth and efficiency of the index, the opportunity to go outside the 500 is more limited than ever. If we look, for example, at US stocks which are not in the S&P, opportunities to buy meaningful stocks outside the index are limited. In fact, the only non S&P name that would make the top 50 is Berkshire. And no OTC name would make the top 100.

In the past, active managers also had the opportunity to buy small stocks. But with billion dollar portfolios being almost commonplace, that opportunity is not so readily available.

If a $2 billion fund, for example, finds General Electric to be too expensive or with poor prospects and in its place has small stocks, it must then buy $60 million worth of those issues. This, of course, creates a series of potential difficulties:

• Since the purchases will likely be a number of stocks, the degree of difficulty is increased. Not only must the decision be correct on the asset allocation, i.e., small stocks, the stock selections must also be correct.

• Trading costs will increase because there will likely be more trades and more expensive trades.

Thus, the active manager who is striving to beat the benchmark must beat it from within. His first option is to overweight key stocks. But overweighting key names is fraught with risk. For an ERISA manager, overweighting a General Electric is likely to raise eyebrows, and significantly overweighting it may result in a pointed inquiry.

Because indexing has made the 500 (at least) so efficient, to beat the index by a significant margin will likely require more negative selection. Since overweighting large stocks is increasingly difficult, the approach that will yield the greatest results is underweighting. But underweighting is a negative approach for which few managers are prepared. Stock picking may be the

forte of some but very few portfolio managers contend they can spot losers. Short sellers or hedge funds may contend that their skills are in this area but they are in a minority and their record over the last five years is hardly reassuring.

Managers might also improve their results by better timing and an improved implementation process. However, few managers have skills in these areas and so continue with the hope that their skills and education will lead to uncovering significant opportunities.

It will be argued that this is not new, that the S&Phas long been in existence and that the performance of managers has been cyclical. Thus, active managers might say, this is just a phase of the cycle and the next phase will see the value of fundamental research, stock selection, and a Stanford MBA.

But in the course of our research we found that the market - and more specifically - the S&Pis becoming a more difficult hurdle.

In 1965 the top decile of the 500 was 60% of the entire index. Additionally ten names were 36.2% of the whole universe. And, AT&T and General Motors were, in 1965, 15% of the world.

The portfolio that correctly assessed the outlook of those two stocks had an extraordinary advantage. And three oil companies were in the top tier. Again, getting that portion correct, provided an incredible edge. Furthermore, AT&T and General Motors -even then - were probably not of the same trading nature as Microsoft or General Electric today. Thus, if one opted not to buy GM in 1964, it was probable that the stock would not run away.

As shown, movements in the key stocks were subdued relative to key stocks today. So underweighting was probably not as uncomfortable as it might be today.

In addition to the large stocks being larger, the small stocks were smaller. In 1965 the bottom 50 stocks were just over .0245% of the entire S&P. Or AT&Twas - by itself - 300 times more important than the bottom fifty stocks!

We have seen an increasing trend toward automated or passive approaches to trading by active managers. Buying slices or portions at regular intervals for the purposes of average weighted measurement is but one example of this. Certain crossing networks are another. Surprisingly, some of the more adept trading is from index funds.

In an example, October 28, 1997, the day after a 500 point drop, we witnessed another demonstration of index fund trading prowess. That morning the market dropped 185 points in the first 36 minutes and was down 1,200 points from its early October peak.

At this point a very broad index-type buy program was effected. In an environment of insecurity and fear, an aggressive buy program had an impact far beyond what one might have expected in a 'normal' supply demand situation. After the market rebounded with the assistance of this activity, natural buyers asserted themselves and the market recovered.

It was an example of the astuteness and acumen of index funds (very few active managers feel a compelling need to buy 400+ stocks in one swipe). After all, if one has $10 or $25 or $50 billion in index funds what is the real risk of aggressively buying $100 or $250 million to buoy existing portfolios?

Passive funds and especially those that track the 500 have a far greater impact than their size dictates. Since they tend to implement their decisions in one sweep, usually at the close, they tend to be price insensitive. This has given rise to a phenomena known as the 'Paris march' where traders purchase vast amount of stocks hoping that index funds will then buy their positions at the close.

Furthermore, if there has been a natural buyer that buyer might accelerate his purchases near the close in hopes that someone else will buy the same stock and make his purchase look even more fortuitous.

Birinyi Associates, as most of our clients are aware, tracks program trading. We do so not for any moral or philosophical reason but because we focus on understanding market trends, elements that move prices, and the forces present and whether or not they are cyclical or secular. In the last several years, we have seen a growing positive impact of buy programs which are not index arbitrage. And increasingly they have also involved large numbers of stocks. We contend that these are index funds making outright purchases. We further contend that this also casts some light on valuations. Index funds take the market higher. Active managers who had uncommitted funds have to invest lest they underperform and have high cash reserves.

These active managers have to buy and do so relatively quickly. And they buy - not surprisingly - large liquid names. Since the first buyers, indexers, don't sell much stock, natural sellers are often brokers and dealers who then cover and so forth.

We appreciate that other forces are at work, other elements exist, but the investor who thinks that passive management is not aggressive is likely to be bulldozed.

REFERENCES:

Indexing, Float, and Liquidity: The Impact of Market Changes; Laszlo Birinyi, Jr.; Birinyi Associates, Oct. 17, 1990.

The Case for Active vs. Passive Equity Investing; Christopher D. Jackson; Trusts & Estates, No. 13, Vol. 135, Dec. 1996.

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