Tesla Fever: Understanding Index Funds And How They May Hurt Your Retirement

If you’ve been following the stock market news lately, you’ve probably heard about Tesla

TSLA
being added to the S&P 500 Index a few times a day. But having a newsworthy change to an index may not mean it’s a good investment—it may just mean the opposite.

Let’s talk about what index funds are and whether they’re a good choice for your retirement portfolio.

What are index funds and why do people like them?

Index funds are a type of mutual fund—a portfolio of stocks or bonds designed to match or track the performance of a particular market index. Unlike some mutual funds which allow managers to have some discretion to select underlying holdings and to determine when to buy or sell them, index funds are designed to track the performance of a market index such as the S&P 500 Index, the Russell 2000 Index, and the Willshire 5000 Total Market Index.

There are some attractive features to these funds.

Since index funds are passive management, managers are not actively picking securities, which means low costs for investors. Also, low portfolio turnover means modest tax impacts. They’re the cheapest means to buy equity exposure, but that may not mean they’re the best option.

Dirty little secret #1: They’re not a broad as you think.

The S&P 500 includes 500 market-cap-weighted stocks. While this sounds like built-in diversification, there’s actually a huge amount of concentration in favor of the biggest names because securities with a higher market capitalization value account for a greater share of the overall value of the index.

Currently, the top five stocks in the S&P 500 index make up over 20% of the holdings. These are Apple

AAPL
(AAPL), Microsoft

MSFT
(MSFT), Amazon

AMZN
(AMZN), Facebook

FB
(FB) and Alphabet (GOOGL). The top 50 stocks account for over 54% of the fund balance (Source). That means that more than half of the index’s return is linked to just ten percent of the stocks in the portfolio.

In terms of your portfolio, while you will own small pieces of 500 different stocks, your portfolio will be weighted in just those big names. That may not be the diversity you expected.

Dirty little secret #2: Mandatory purchases and sales.

The manager of an index fund has less flexibility in terms of what to buy, what to sell or when to make the transactions.

Let’s look at Tesla (TSLA). This year, there was tremendous talk about the possibility of Tesla joining the S&P 500 Index. That drove up the stock price. Since the beginning of 2020, the value of Tesla stock has grown more than 600%.

Tesla will be joining the index later in December. Managers will be forced to establish positions in Tesla stock, and they’re buying the shares at a grossly inflated price.

If you own the S&P 500 Index, you’re about to own a lot of Tesla stock—but only after its price has been escalated to all-time highs.

When a stock is announced to be joining an index, the managers of the funds mirroring that index have no choice but to buy shares. But a lot of institutional and individual investors buy up the shares before those managers can, so index funds often buy at an elevated price on the way in.

The same thing is true in reverse. An index fund may have less flexibility to react to price declines in the securities within the index. If a stock gets kicked out of an index, the managers have to sell the shares whether they want to or not. That will drive the price down.

To have a successful outcome for an investment, an investor should choose what to buy, when to buy it and when to sell it. Getting any of those three components wrong can hurt returns, and index fund managers don’t get to select any of the variables on their own merits.

In my opinion, the newsworthiness of a stock joining or leaving an index almost always leads to a public buying or selling frenzy and then a lousy deal for the index fund holders.

Dirty little secret #3: There’s no defense.

When constructing a portfolio, asset managers look at various measures, including those known as alpha, beta and standard deviation.

Alpha is a measure of the fund manager’s selection skill. A positive alpha can add value to the fund. A negative alpha can detract value.

Index funds have no alpha because there is no control over selection—it’s all predetermined by the index, so it sets its own benchmark. You can never get excess performance on the upside or downside, so you can never do better than the benchmark.

Beta is the measure of risk. A beta of 1.00 means you’re taking the exact amount of risk as the benchmark, in this case the S&P 500. If a beta is higher than 1.00 you’re taking more risk than the benchmark and if its less than 1.00 you’re taking less risk than the benchmark.

An index fund always has a beta of 1.00. You’re not creating any additional defense against risk.

With no alpha or beta, the standard deviation will be higher for an equity index fund than you may want for your portfolio because it cannot play any defense.

If the S&P index is up 40%, so is your portfolio. If its down 40%, so is your portfolio.

The best way to manage a portfolio is to reduce that downside. The force of the downside is double the force of the upside.

Understanding downward pressure.

Let’s say you make a hypothetical investment of $10,000 into an index and hold it for two years. In the first year, the fund gains 50%. In the second year, the fund loses 50%. The average annual rate of return is zero, but you still lost money. After year one, you had $15,000. After year two you had $7,500.

The same is true in reverse—the sequence doesn’t matter. If you lost 50% in the first year and gained 50% in the second year, you’re still coming up with less than you put in.

The lesson:

Cheaper or inexpensive is not always the better choice when investing.

Passive asset management for widely traded asset classes may make a ton of sense, but you don’t have to buy an index to be passive. All you need is fund that’s primarily buy-and-hold and has low turnover. This won’t be as cheap as an index fund, but it can still be inexpensive. It also has a chance to increase alpha and to reduce beta by avoiding some of the higher standard deviation positions in the index.