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Skarbeck: Risk measure stokes debate over merits of index funds

September 6, 2014

Ken SkarbeckLetters of the Greek alphabet are used by the investment industry to describe measurements of investment performance and risk. Alpha and beta are the two most common statistics calculated by investment academics.

Alpha is described as the excess return achieved above an index return. Therefore, it is thought of as a measure of an investor’s skill in outperforming the market.

Beta is a measure of volatility, and thus, many believe, a measure of risk. The more a security fluctuates in price around a benchmark index return like the S&P 500 index, the higher its beta. High-beta stocks are considered riskier, yet purport to offer the potential for a greater return than the market. And vice versa, low-beta securities have less price volatility in relation to the market and are thus perceived to have less risk, and consequently are assumed to harbor lower potential returns.

While the goal of many investors is to create alpha, in other words “beat the market,” it is a well-known fact that most investors (including professionals), underperform the market over the long run.

Hence, the argument to buy index funds. Investors who invest in index funds accept the aggregate ups and downs (volatility) of the broad stock market, which is equivalent to a beta of 1. Conversely, a stock like First Solar, with a beta of 2.3, is subject to much wider price swings relative to an index fund. Likewise, Duke Energy, a utility with a beta of 0.24, doesn’t fluctuate in price nearly as much as the market index.

Vanguard’s founder, John Bogle, has been a vocal advocate for index funds because of their low cost and as a “passive” investment, since there is no effort expended to attempt to outperform the market via individual security selection.

And what is there not to like? Investors in the S&P 500 index have enjoyed excellent returns since the nadir of the credit crisis. For the five years spanning June 30, 2009, through June 30, 2014, the S&P 500 with dividends reinvested has returned 18.8 percent annually. It should be noted that it took some intestinal fortitude to proactively buy stocks in 2009, but stock prices were cheap and those who did have been well rewarded.

A quick look at the five-year returns in the Indiana CollegeChoice 529 Direct Savings Plan shows that the U.S. Equity Index Portfolio has significantly outperformed the 14 other available investment options.

All that said, index investing has its critics. One flaw is that, in a capitalization-weighted index like the S&P 500, a handful of the largest securities contribute heavily to the overall index performance. Since Apple Computer is the largest company in the index, valued at $592 billion, its contribution to the performance of the S&P 500 is 3.5 percent. Whereas, the smallest constituent of the index, most recently Urban Outfitters, valued at $4.1 billion, has only a 0.02-percent weight in the overall index performance.

In fact, the top 10 stocks in the S&P 500 have a combined weight of 17.8 percent, which has naysayers arguing that index investors are buying the stocks that have already gone up the most and which may be overvalued.

Not one to miss a sales opportunity, Wall Street has come forth with a new breed of index investing, to be explored in my next column.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
 

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