Reader Mailbag: How is the stock market index of any significance for individuals?

This week, we have a reader question from Jasmin:

How is the stock market index of any significance for individuals?

The significance of a stock market index (or any other index for that matter) is that it is a benchmark. In other words, investors can use indices as a yardstick to measure and/or compare slices of their portfolio to.

For most investors, indices can be used to evaluate the performance of the individual asset classes in their portfolio. Investors can compare the risk and return metrics of an allocation to those of an appropriate index. When utilizing an actively managed strategy, an appropriate index or index fund can be viewed as the opportunity cost of using the active strategy.

If you own US large-cap stocks, you might compare the volatility and performance of those stocks to the S&P 500. If you own international stocks, you might compare them to the MSCI EAFE. You can compare the bond portion of your portfolio to the Barclays Agg or a number of other indices. There are multiple indices for various sectors, regions, countries, and so on. In fact, today there are more indices than stocks!

Although the above is relatively straightforward, many investors misuse indices. Below are two of the more common errors that I see:

  • Comparing a multi-asset class portfolio to a single asset class index. I meet many people who compare their portfolio of global stocks and fixed-income to the S&P 500. The S&P 500 could probably be used to benchmark the US large-cap equity portion of the portfolio, but certainly not the entire portfolio.
  • Viewing an index as a goal. Each individual investor has unique goals and their portfolio should reflect this. Even the largest indices have some fairly substantial risks, which investors should be aware of and may want to avoid. For instance, the “China Region” (China, Hong Kong, and Taiwan) makes up 40+% of most broad-based emerging markets equity indices or the Barclays Agg is overwhelmingly government bonds, which offer much more duration than yield today. These are just two examples of where investor goals may be inconsistent with an index’s composition. Note: Money managers may benchmark to a single index, but this is because they typically run single asset class strategies and are concerned with relative performance, neither of which is typically true of individual investors.

So, the short answer is that individuals can use indices to evaluate single asset class strategies/managers and should not be used for much more than that.

Asset Classes: Active vs Passive

If nearly all investors engage in active management through the development or selection of a portfolio’s asset allocation, then what is the active versus passive management debate all about?

The debate is whether individual asset classes should be accessed via active managers or via passive strategies. Thus, the debate over active versus passive management is at the asset class level, rather than portfolio level (because all investors are active at the portfolio level!).

Below is a brief summary of active and passive management:

Active:
The traditional form of investing, where an investor picks individual securities that he or she expects will result in the best risk or return metrics.

Passive:
At some point (I think in the 1950s) investors began to both deduce and notice that active managers (in the aggregate) could not outperform the average returns in various markets. If managers could not beat the averages, then investors would be better off accepting average returns and minimizing costs. Average returns could be nearly achieved by simply buying the entire market or a representative sampling of them.

Below is an example of where an investor must decide whether to utilize an active or passive strategy:

A hypothetical investor decides to allocate 10% of her portfolio to emerging markets bonds. The investor can do one of two things with the 10%:

  1. Purchase individual emerging markets bonds (or hire a manger that selects the “best” bonds, based on research, analysis, etc).
  2. Invest in a passive strategy that attempts to mirror the risk and return characteristics of the broad emerging market bond market.

If the investor is comfortable with the risk and returns of the broad emerging market bond market, she should consider a passive strategy. If not or she thinks that she can beat this market, active management may be a better choice.

It should be clear that neither active management nor passive management is inherently better. The decision to use one over the other should depend on both investor objectives, as well as the asset classes’ characteristics and market structure. Yet, the debate does carry on, which I believe is driven both by bias from investing product sponsors and by dogma from under-informed investors.

Looking ahead, we will examine various asset classes and how active and passive strategies fare in each.