More than 20 Trillion (T) Dollars are managed passively today. The industry is 25% of the total $100 T investment management industry and has seen an annual growth of 20% since 2007 while the Active industry has grown at 4.4% for the same period at these growth rates. At the current growth rates, Passive should overtake Active in 7.5 years. In 1975 there was no Index fund. In less than 50 years, everything seems to transform into Passive. All these statistics are based on two assumptions. First, Active can never get its act together to beat the S&P 500. Second, The S&P 500 epitomizes passive. These assumptions are erroneous.
"The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge."
This quote is attributed to the renowned theoretical physicist Stephen Hawking. The quote highlights the danger of being overconfident in what we think we know. It is a reminder that assuming we have knowledge or understanding of something without actually verifying it, can be a greater impediment to true learning than not knowing something at all. It suggests that to expand our knowledge and understanding, we must remain humble and open-minded, always willing to question what we think we know and seek out new information and perspectives.
The industry’s inability to question the two assumptions not only illustrates poor scientific rigour but also a lack of academic courage, an essential ingredient for innovation. If the respective assumptions are indeed incorrect, Investment management becomes the biggest tragedy of commons which has driven the largest wealth destruction for global investors, even more than the active investment industry, an industry that passively believes it has reformed.
Let’s unpack the second assumption.
Is S&P 500, the leader of the passive industry, really passive?
What is Passive?
Passive is buying or replicating broad market Indexes, it is about "buy and hold", is for the long term, involves minimal trading, is considered cheaper, less complex than other financial instruments, and often produces superior after-tax results compared to active investing. According to a 2021 Gallup poll, 71% of U.S. investors say index funds work better than stock-picking. 89% say "time in the market" is a better strategy than "timing the market”. The “Set It and Forget It" Mindset defines passive.
The Legend of Invincibility
Historically, there have been many legends of invincibility.
Achilles: In Greek mythology, Achilles was a hero and warrior who was said to be invincible except for his heel, which was his only vulnerable spot. This legend gave rise to the term "Achilles' heel," which is still used today to describe a person's weakness or vulnerability.
Sigurd the Dragon Slayer: In Norse mythology, Sigurd was a hero who was said to be invincible due to his magical sword, Gram, which he used to slay the dragon Fafnir. However, he later met his demise due to treachery by his allies.
The Legend of Karna: In Hindu mythology, Karna was a warrior who was born with invincible armor and earrings that granted him special powers. However, due to a curse, he lost these protections during a crucial battle and was ultimately killed.
Then there was the Jade Emperor's Invincible Armour. According to Chinese mythology, the Jade Emperor, also known as Yuhuang Shangdi, was the supreme deity and ruler of heaven. The Jade Emperor was said to have an invincible suit of armor that protected him from harm. This armor was made from magical materials and was said to be impenetrable. The story goes that the Jade Emperor was once challenged to a battle by a powerful demon. The demon was known for its strength and invincibility, and many believed that it would be impossible to defeat. However, the Jade Emperor donned his invincible armor and went to battle with the demon.
The battle was long and fierce, but in the end, the Jade Emperor emerged victorious. His invincible armor had protected him from all of the demon's attacks, and he was able to defeat the demon with ease. After the battle, the Jade Emperor's invincible armor became a symbol of his power and strength. It was said that no one could defeat the Jade Emperor while he wore his invincible armor, and this legend served as a reminder of his divine status and invincibility.
The story of the S&P 500’s invincibility is like the Jade Emperor. The hero remains invincible for eternity. The few kinks in the armour of this story is that it’s not true, is motivational and fictitious. History of Indexing Maths has well documented the vulnerability of the methodology that drives the S&P 500. The making of index numbers, by Irving Fisher, demystifies the legend.
If you buy something today for $10, and its price increases by $2, the value of your holding should not go up more than 20%. But in the case of S&P 500, every time something goes up, it is given more weight, or allowed to inflate in value. The invincibility has nothing to do with the logic of mathematics but everything to do with the convenience of calculation of an 1871 equation written by Ernst Louis Étienne Laspeyres, a German who was the representative of Kathedersozialismus [The historical school of economics]. The historical school held that history was the key source of knowledge about human actions and economic matters, and hence not generalizable over space and time. The school rejected the universal validity of economic theorems. They saw economics as resulting from careful empirical and historical analysis instead of from logic and mathematics. The school also preferred reality, historical, political, and social, as well as economic, to mathematical thinking.
Buy and Hold
Does the underlying S&P 500 buy and hold? From a methodology perspective, S&P 500’s market capitalization weighting methodology, overweights big-size companies as it scales up weight with every rise in price in a component and scales down weight with every fall in price. So it’s never one allocation at a specific time that is bought and held. Every allocation continues to change with the smallest change [tick] in price. So even if S&P 500 does seem like buy-and-hold an investor can’t replicate the S&P 500 Index by buying and holding.
Rather S&P 500 method is designed to overshoot the buy-and-hold portfolio in a rising market and undershoot the buy-and-hold portfolio in a falling market. S&P 500 oscillates around a buy-and-hold strategy and the more time you will give it, the more risky amplification it will do, creating an illusion of paper money in a rising market, and an illusion of more loss in a falling market.
Replicating Broad Market Index
The underlying S&P 500 unlike popular belief is not a broad market index because 80% of its weight is owned by 20% of the component stocks. The S&P500 and most other broad indexes owing to the market capitalization weighting method i.e. bigger the size, the bigger the weight creates an imbalance and does not give a diversified exposure. Hence, the 500 stocks of the S&P 500 can be replicated by as few as 25 stocks. So, the idea of replicating a broad index is incorrect. Passive Index funds, replicate the broad market with a sliver of the broad market because the more the weight concentration less the number of stocks are required to replicate the S&P 500. In 1964, the five largest stocks owned 28% of the S&P 500. Sectorally APPL owned nearly 20% of the FAANG group at its peak. So much so, that it does not matter whether you buy S&P 100 or S&P 500, in both cases you are owning these similar stocks.
Long Term
The average time that stock remains in the S&P 500 can vary widely from year to year, depending on factors such as mergers and acquisitions, bankruptcies, and shifts in the overall economy. However, a study by S&P Dow Jones Indices found that the average tenure of companies in the S&P 500 was 33 years in 1964. By 2016, this had declined to 24 years, and the average tenure will likely continue to decrease in the future due to the fast pace of technological disruption and competition in many industries.
It's difficult to determine an exact average time that all 500 stocks spend together in the S&P 500, as the index is regularly reconstituted and individual stocks can be added or removed at any time. However, one way to estimate the average time all 500 stocks spend together in the S&P 500 is to look at the historical data on the turnover rate of the index, which is the percentage of stocks that are replaced each year. According to a report by S&P Dow Jones Indices, the average annual turnover rate for the S&P 500 from 1990 to 2020 was about 6%, which means that about 30 of the 500 stocks in the index were replaced each year on average.
Using this turnover rate, we can estimate that the average time that all 500 stocks spend together in the S&P 500 is roughly 16-17 years (i.e., 1 divided by 6% turnover rate). Let's assume 15 years to be the average time all 500 stocks are together. Now this time will vary for large companies and small companies as S&P 500 allocates more weightage to large companies and less weightage to small companies. An estimate can suggest large capitalized stocks are held for an average of 20 years, while relatively smaller-sized companies can be held for around 10 years. This means that a significant proportion of what you believe is long-term maybe only held for an average of 10 years. There is not one but many alternative methods to build an Index that can reduce concentration, increasing returns while increasing long-term average holding for S&P 500 components and hence halving the time to double investors' wealth.
Risk Perception
Generally, larger and more established companies with higher market capitalizations tend to have lower turnover rates and longer holding periods, as investors may perceive them as less risky and more stable over the long term. Smaller companies with lower market capitalizations may be subject to higher levels of volatility and uncertainty, which could lead to shorter holding periods among investors.
Minimal Trading
Since S&P 500 value changes daily, Index funds and ETFs need to buy and sell units daily. Rather ETF’s secondary market feature brings in more trading which increases noise and risk for investors who assume Index funds are minimally traded. ETFs are now a significant percentage of the total trading volume in the underlying market.
Rebalance Illusion
When an index rebalances its weights, it means it is adjusting the amount of each stock or security in the index to ensure that the index continues to accurately represent the market it tracks, based on a predefined methodology. It’s only a perception that Passive Market Capitalized (MCAP) weighted Indexes don’t rebalance. The S&P 500 MCAP methodology is designed to increase or decrease the weights of components with every increase in tick change, which means the rebalance is perpetual.
Slow Recovery
Yes, passive is cheaper compared to active funds. But just because Passive is near zero fee does not mean it does not underperform. VVFIAX has trailed the index since its inception. And because it is cheaper and assumes concentration risks, passive is slow to recover, once it enters a bear market, and can persist in bear market for a longer time, compared to many other alternative methods to build an index. Many global economies are still below their 2007 peaks and it has less to do with what the economic growth but more because of the poor design of the methodology driving Indexes like the S&P 500.
Performance - Vanguard VFIAX 500 Index Fund Admiral Shares
Most benchmarks today run like the S&P 500 with the 1871 methodology and hence either they are licensed by S&P or the benchmarks are run themselves with the market cap weighting methodology. Together they all rise and together they all stay in red. It has taken on average 20 years for benchmarks to recover from their respective peaks. The current methodology creates a lot of dis-service for simple investors as they struggle to conserve and generate wealth. Current passive methodologies ain't really passive. The reduce returns and are slow to recover.
The Indexes coloured red are still in recovery.
Conclusion
A less concentrated method that increases the average long-term holding and increases risk weighted outperformance will demystify the current passive. Today’s passive ain’t passive because it is inflated for positively trending times, and deflating for negatively trending times. The S&P 500 is not the only way to represent the market and owing to its poor design as first explained by Irving Fisher, is harming long-term investors. Every year passive investors lose 3-5% of their wealth to the small management fees but more importantly to underperformance to a better Index, a more passive, a better alternative to the S&P 500.