Why I don’t (always) like index tracker funds
How do you make $15bn in a day?
It’s easy enough if a) you’re Elon Musk, and b) your electric car company Tesla is added to the S&P 500 index.
Tesla’s share price shot up faster than a SpaceX rocket on the announcement, pushing Elon’s 20% stake in the company up to $117.5 billion – he’s now the third richest person in the world.
But the entry of Tesla to the S&P 500 raises an important question about index tracker funds, an increasingly popular way of accessing investment markets.
Coming up in this video and blog, two reasons why I don’t always like index tracker funds – and why Tesla joining the S&P 500 makes those reasons even more important.
In this video, prompted by the news that Tesla is set to enter the S&P 500 index on 21st December, a closer look at some of the downsides associated with index fund investing.
I want to start by looking at the news Tesla is becoming part of the S&P 500.
What is the S&P 500?
It’s a stock market index that measures the stock market performance of 500 large companies listed on stock exchanges in the United States.
The S&P 500 is one of the most commonly followed equity indices in the world, created back in 1957.
There are strict rules to be part of the S&P 500, which is why Tesla is only now being admitted.
You have to meet the 8 primary criteria, which include market capitalisation (your size), liquidity (how well-traded your stock is), and financial viability (i.e. profitability).
Tesla has now reported 5 consecutive quarters of profits, after recording losses for most of its history.
It nearly made it into the S&P 500 in September, but reportedly missed out because the committee was worried about the stability of its earnings.
One implication of Tesla joining the ranks of the S&P 500 is that funds which track the index will invest in the company. Automatically. Without discretion.
That’s because the S&P 500 index is a free-float capitalization-weighted index.
The companies that make up the index are weighted in the index in proportion to their market capitalisations, based on the number of shares available for public trading.
This free-float capitalization-index approach for how the index is constructed is important to understand if you’re going to invest using an index tracker, because it can lead to a big allocation to a small number of stocks.
There might be 500 stocks in the index, but the 10 largest companies make up 26% of its market capitalisation.
In fact, as things stand, 5 companies represent 23% of the market capitalization of the S&P 500 index. Apple, Microsoft, Amazon, Facebook and Google.
We know as investors how important diversification is; not keeping all of your eggs in one basket.
When Tesla enters the index next month, that lack of diversification will be further amplified.
So reason number one I don’t always like index tracker funds, if that they don’t necessarily offer you diversification – you can end up in an extremely concentrated portfolio of the most expensive companies.
I know some Financial Planners refer to index tracker funds as a way to own the best companies in the world. Technically, yes, you own a lot of companies, but each of those companies might represent a minuscule amount of your overall portfolio.
Work your way down the list of S&P 500 companies, and you find the likes of Fox Corporation, in 494th place, at 0.014% of the index. Or Ralph Lauren (in 498th place) with 0.013% of the overall market cap.
Huge companies, but with tiny allocations in the index, because the biggest companies (Facebook, Apple, Amazon, Microsoft, Google, Tesla) are significantly larger by market cap.
Moving on then to my second reason I don’t always like index tracker funds, and that’s because they can be unethical.
There is a large and growing movement towards ESG investing – Ethical, Social, & Corporate Governance investing.
Index trackers are fundamentally at odds with this ESG investing movement.
When you invest in an index, you buy everything – the ethical and the not so ethical. Want to invest in oil? Buy an index tracker fund. Mining giants? An FTSE 100 index tracker fund is packed full of those.
Despite being automatically exposed to a range of good, bad and indifferent (for the planet and for society) companies, index tracker fund managers do appear to exercise their influence for good.
A study from Wharton University, in a paper called ‘Passive Investors, Not Passive Owners’, found that passive investors pressed effectively for shareholder-friendly policies like increasing the number of independent directors and removing poison pills and dual-class share structures.
Professor Donald B Klein from Wharton said the index-style companies “are increasingly becoming more proactive in their proxy voting. Thus, passive institutional investors have a very important, yet unstudied and undocumented, influence on corporate governance. Our paper is the first to provide evidence on this important relationship.”
There’s an argument that being stuck with a company in your portfolio, because it makes up part of the index, gives you a strong incentive to make it perform better. You can’t put management under pressure by threatening to sell their stock; you have to hold it for as long as it remains in the index.
But index tracker managers can lend their votes to activist investors, giving them more power, and therefore forcing through positive change.
The report says: “A 10% increase in passive ownership is associated with a 4% decline in support for management proposals and a 10% increase in support for proposals considered shareholder-friendly.”
So, you might still invest in companies that are killing the planet or harming society, but owning them via an index tracker fund will at least help influence some positive changes in the future.
That’s two good reasons not to be a fan of index tracker funds. But there are plenty of good reasons to like them too!
We recommend them within our client portfolios and there is a growing role for index tracker funds, used well.
In large, efficient markets, such as the US equity market, index trackers tend to offer a better option than active fund management.
There are plenty of academic studies which demonstrate that, on average, an active fund manager will underperform its benchmark. When you invest using an index tracker fund, you know you’re going to get what it says on the tin, and at a very low cost too.
Keep in mind that not all index tracker funds are born equal; some are far more expensive than others, and some use different replication strategies, adding counterparty and other hard to quantify risks to the process.
Some actively managed funds are better than others too.
Those that have a high active share – that deviate from the benchmark – tend to do better than those that are closet index trackers, hugging a benchmark but charging you more for the privilege.
It’s too simple to say index trackers, good and active funds, bad, simply by comparing the best index tracker funds with the average actively managed funds. High active share offers a tool for finding those actively managed funds that are more likely to outperform their benchmark.
What do you think about Telsa joining the S&P 500 index? Will it make you reconsider your index tracker fund?