As the stock market has continued its broad-based rise over the past nine years, many investors have favored index-based investing over actively managed strategies. In addition to cost and tax benefits, index investing can help avoid investor biases such as hindsight, herding, overconfidence, and extrapolating. Accordingly, the JNBA Investment Committee utilizes conventional index strategies where appropriate. However, when evaluating the index market, JNBA believes that at times there may be better index approaches than the traditional market-cap-weighted indexing approach in many portfolios.
The majority of indices such as the Standard and Poor’s 500 Index base position size solely on the total value of the shares or market capitalization of each constituent (or member of the index); the larger the company the larger the weight it represents in the index. However, this attribute of cap-weighted indices tends to run contrary to both the law of large numbers and the law of averages. For example, Apple is the largest company in the world and comprises approximately 3.5% of the S&P 500 due to its massive size (valued at approximately $730 billion). In order for Apple to double in value it would have to increase to a staggering worth of almost $1.5 trillion—about 10% the size of the U.S. economy. While Apple may be an attractive name to own in a portfolio for a variety of reasons, the probability of other names doubling in value is much greater.
Below is a chart of the S&P 500 compared to a composite of whichever stock was the largest, within the index, for the given time period. This illustration shows significant index outperformance relative to the largest companies, demonstrating that relative to the passive index, performance could have been enhanced simply by excluding the largest company for each time period and essentially investing in 499 of the 500 companies.
Criteron other than company size that are used for the construction of alternative strategies or indices are called “factors.” The use of factor-based strategies changes the risk and return profile of the investment and may be beneficial in applications and time periods.
Some of the investments we use in our client portfolios include factors exposures such as quality of earnings and cash flows, dividend payment history and longevity, and value (discount to estimates of intrinsic value) among others. We believe that portfolios constructed based on these factors, not merely company size, have the ability to provide enduring incremental returns over full market cycles and that our clients will benefit in the long term from this different approach to equity exposure. While there are reasonable applications for market-capweighted exposures (including short to intermediate-term tactical exposures), there is also a place for factor-based strategies, particularly in the long-term core exposure of a portfolio.
If you have questions about factor-based strategies, and how they might be used in your portfolio, please contact your advisor.
Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from JNBA Financial Advisors, Inc.
Please see important disclosures information at www.jnba.com/disclosure