After long periods of steadily rising markets, like we’ve experienced for most of the last 5 ¾ years, there is a predictable theme that comes to the forefront of investment conversations. The concept of indexing or passive investing is touted as the best way to go because most actively managed investment funds don’t beat their benchmark indexes during periods of rising markets.
The problem inherent in this argument is that index style investing generally gets riskier as market trends go on for longer periods of time. Index funds are required to hold their investments in proportion with the index the fund is based on. The most common example is the S&P 500 Index. Most indexes are capitalization weighted, meaning the largest companies as measured by the value of all their outstanding shares have a larger weight in the fund. So, companies like Apple, Exxon Mobil and Microsoft have a higher weighting than smaller companies like AutoZone or the WD-40 Company.
At the end of bull markets, these large companies tend to appreciate more than smaller companies meaning that index-based investors have more of their money in the companies that may be the most over-valued. This works great until the next downtrend starts and the over-valued companies fall more than the average company. This is what happened to technology stocks in 2000 and financial stocks in 2008.
An active fund manager does not have to maintain index like exposure and, in fact, should be acting to reduce the weight of over-priced securities in the fund. So, one way that active managers may add value is not through beating the market when times are good, but by going down less during market downturns.
Recently, the decline in oil prices hit the high yield corporate bond market hard. In previous years energy companies issued a lot of debt to develop operations in the shale oil and gas fields here in the U.S. In bond indexes, the amount of bond issuance determines the allocation that a bond index fund must hold, so many funds were over-weight energy related bonds when the decline occurred. Some high yield bond index funds were down as much as 20 percent. Most actively managed funds stayed away from the trouble and declined far less.
In summary, we believe there is nothing wrong with indexed or passive investing, but investors should have an understanding of the potential for increased risk at certain times in the market cycle. Index funds do offer some advantages, such a low expense ratios and transparency or what is owned in the portfolio. All these factors should be taken into account when building your portfolio.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.