I’ve written before about “the sheer absurdity index funds.” The lunacy continues.
News emerged this week that the stewards of the Dow Jones Industrial Average used the occasion of Apple’s recent 4-for-1 stock split to reshuffle the index to boot out Exxon Mobil, Pfizer and Raytheon from the Dow. To me, the move again reinforces just how ridiculous it is to have an investment strategy that slavishly copies a market index.
Because the Dow is a “price-weighted” index, a higher share price means a stock carries a larger weight in the index. This in itself is absurd. The price of one share of a company’s stock tells us NOTHING useful whatsoever about it. It is largely an arbitrary function of the number of shares on issue. A $300 stock is not necessarily “more expensive” than a $10 stock; even novice investors know that much.
But the Dow has always been calculated as an arithmetic average based on prices of shares in the index, and not based on market capitalisation weightings like the S&P 500 is. In the S&P, a 1% move in a $1-bn company, quite logically, has a smaller impact on the index than a 1% move in a $1-trn company.
It is also worth keeping in mind, Charles Dow dreamt up the Dow Jones Industrials Average 124 years ago, when motor cars were a brand new technology and most people still rode around using horses and buggies.
Yet people still seem to think that the Dow, and the way it is calculated, is relevant to today’s world. How quaint.
It’s like using abacus in a world where people use their mobile phone calculators. Or using a sundial to tell time instead of your smartwatch.
Going back to Apple’s 4-for-1 split, because that shrinks the weight of Apple in the Index, and thus lowers the weight of the “Information Technology” sector in the index, the good folks at S&P Dow Jones decided to do the following to the Dow:
And simultaneously remove:
Is there any LOGICAL reason for these changes?
If one were a cynic, one could argue it is a move by the index overlords to “sex” up the index and make it more “new economy” and pandemic resilient.
Removing Exxon would also get a big tick of approval from the woke, social do-gooders, ESG investors, and anti-climate change crowd, led by poster-child (literally) Greta Thunberg.
I just think, once again, it serves to illustrate how absurd it is to base one’s investment decisions on what stocks are in any particular index.
Unless you are a trader, trying to front-run index changes, or a value investor trying to pick up bargains in stocks that have fallen because they got dumped from an index, why would you pay any attention to the indices? They are arbitrary.
Surely in business THOSE are the factors that matter to you?
Why would assessing the investment merits of a publicly traded company be any different from assessing a private business?
The only reason is because we have all been sold a white lie… that indices matter, and that they are the arbiters of quality and the only valid benchmark against which to measure one’s investment performance. I completely disagree with that notion.
I have a rule that unless I am speculating in mining exploration stocks – which I do from time to time with a small portion of my portfolio — I don’t like to own money-losing companies. I also don’t like to own companies with anywhere near the levels of debt that the average company in the advanced economies seems to employ nowadays.
Following these rules, I simply won’t invest in an index. I don’t want the money-losing, debt-bloated companies that come bundled with the index. It’s like buying a heavy basket full of fruits with the pretty ones on top, not knowing which ones are rotten at the bottom.
Of course, I might underperform the index by not owning the market darlings that come with it either.
But that’s OK, I believe that by avoiding money-losing firms and firms with vulnerable balance sheets, I am taking on significantly less risk.
For the African Lions Fund, for example, we have very strict criteria around profitability and debt levels of all the companies we will consider investing in. We will never own a company based solely on whether it is in an index or not. It’s absurd.
We do reference the S&P Sub-Saharan Africa Frontier BMI Total Return Index. And we only get paid performance fees if we outperform it. But we aim to do that precisely by NOT owning all the turkeys that it contains, instead only owning the good-quality juicy fruits at the top of the basket.
Until next time,
Founder, Global Value Hunter
& African Lions Fund