The S&P 500 is not a passive index

 The S&P 500 is not a passive index

The notion that the S&P 500 is a perfect example of passive investing is incorrect and demonstrates a lack of scientific rigor.

Contrary to common assumption, the underlying S&P 500 is not a broad market index since, according to Mukul Pal, 20% of its component stocks account for 80% of its weight.

Today, more than $20 trillion is passively managed. The sector, which accounts for 25% of the $100 trillion global investment management market, has expanded at a rate of 20% per year since 2007 compared to 4.4 percent for the active market. It will take 7.5 years for Passive to surpass Active at the present growth pace.

There was no Index fund in 1975. Based on a few presumptions, everything seems to have changed to passive in less than 50 years. Firstly, Active never manages to outperform the S&P 500. The S&P 500 is the perfect example of Passive. These are incorrect presumptions.

"The greatest enemy of knowledge is not ignorance; it is the illusion of knowledge." This quotation, ascribed to the well-known theoretical physicist Stephen Hawking, emphasizes the danger of overestimating our level of knowledge. It serves as a reminder that supposing we know something without checking might really hinder our ability to learn more than not knowing anything at all.

It implies that in order to increase our knowledge and comprehension, we must have an open mind and always be prepared to challenge our assumptions by looking for fresh data and viewpoints.

The industry's unwillingness to challenge the two presumptions demonstrates a lack of intellectual bravery, which is a necessary component of innovation, as well as a lack of scientific rigor. If the aforementioned assumptions are shown to be false, investment management—rather than the Active investing sector, which Passive claims to have transformed—becomes the worst tragedy of the commons that has destroyed wealth for investors worldwide.

Now let's examine the second supposition: The benchmark for the passive industry, the S&P 500, is it really passive?

Describe Passive.

Purchasing or copying broad market indices is known as passive investment. It is a long-term strategy that includes "buy and hold" and no trading. It is also seen to be less expensive and difficult than other financial products, and it often yields better after-tax returns than active investing. A Gallup study conducted in 2021 found that 71% of US investors believe index funds outperform stock selection. "Time in the market" is a better technique than "timing the market," according to 89% of respondents. Passive is defined as a "Set It and Forget It" mentality.

The Myth of Unbreakable Success

There have been various myths about invincibility throughout history, notably Achilles. According to Greek mythology, Achilles was a warrior and hero who was unbeatable but for his one weak point—his heel. The phrase "Achilles' heel," which still refers to a person's weakness or fragility, originated from this fable. And then there came the Invincible Armour of the Jade Emperor.

The Jade Emperor was thought to be shielded from attack by an unbreakable armor set in Chinese legend. According to legend, a formidable monster once challenged the Jade Emperor to a fight. The Jade Emperor ultimately prevailed in the protracted and intense fight. The Jade Emperor's unbreakable armor came to represent his might and might after the fight. The mythology that the Jade Emperor was unbeatable while he was wearing his impenetrable armor served as a constant reminder of his heavenly status.

The S&P 500's unstoppable tale is comparable to that of the Jade Emperor. The hero is unstoppable indefinitely. The fiction nature of this narrative is a weakness in its armor. The mechanism used to calculate the S&P 500 is vulnerable, as the History of Indexing Maths has extensively demonstrated. Irving Fisher's explanation of index number creation demystifies the tale.

The worth of the item you purchase today for $10 should not rise by more than 20% if its price increases by $2. However, in the case of the S&P 500, an increase in value is accompanied by an increase in weight.

The invincibility stems entirely from the ease of calculating an equation written by German representative of the historical school of economics, Ernst Louis Étienne Laspeyres in 1871. This equation has nothing to do with the logic of mathematics. According to the historical school, history is the primary source of information regarding economic and human behavior, and as such, it cannot be generalized across place and time. The school disregarded economic theories' general applicability. Rather than coming from logic and mathematics, they believed that economics was the product of rigorous empirical and historical study. In addition, the school valued historical, political, social, and economic reality above mathematical reasoning.

Invest and Hold

Is the S&P 500 underlying index a buy and hold? Larger companies are overweighted by the S&P 500's market capitalization weighting methodology, which increases component weight with price increases and decreases weight with price decreases. Thus, an allotment is never purchased and retained at a single moment in time. Even the slightest shift in price causes every allocation to alter.

An investor cannot mimic the S&P 500 Index by purchasing and holding, even if the S&P 500 does seem to be a buy-and-hold investment. The S&P 500 approach, on the other hand, aims to undershoot the buy-and-hold portfolio in a down market and overreach it in a rising one. The buy-and-hold strategy is the basis of the S&P 500's oscillations; the longer you give it, the riskier the amplification will be, giving the impression of paper money in a rising market and greater loss in a declining one.

Duplicating the Index of Broad Market

Contrary to common assumption, the underlying S&P 500 is not a broad market index since 20% of its component stocks account for 80% of its weight. Due to the market capitalization weighting approach, which states that the higher the size, the bigger the weight, the S&P 500 and most other broad indexes generate an imbalance and do not provide a diversified exposure.

Therefore, 25 equities may mimic the 500 stocks in the S&P 500. Therefore, it is inappropriate to replicate a wide index. The top five stocks accounted for 28% of the S&P 500 in 1964. At its height, Apple's share in FAANG was close to 20% in the sector. So much so that purchasing the S&P 500 or the S&P 100 makes no difference. In all scenarios, you wind up with comparable stocks.

Extended Duration

A stock's average duration in the S&P 500 might vary significantly from year to year based on a variety of events, including bankruptcies, mergers and acquisitions, and changes in the general state of the economy. But according to a 1964 S&P Dow Jones Indices research, the average duration of S&P 500 enterprises was 33 years. This has dropped to 24 years by 2016, and given the rapid speed of technological innovation and industry competitiveness, this average tenure will probably keep falling in the future.

Since the S&P 500 is constantly being reconstituted and individual companies might be added or deleted at any moment, it is difficult to pinpoint the precise average amount of time that all 500 stocks spend together. Nonetheless, historical data on the index's turnover rate—that is, the proportion of stocks that are replaced annually—can be used to calculate the average amount of time that all 500 stocks in the S&P 500 spend together. The S&P 500 had an average yearly turnover rate of almost 6% from 1990 to 2020, according to a research by S&P Dow Jones Indices. This implies that, on average, 30 out of the 500 companies in the index were replaced annually.

Based on this turnover rate, we may calculate that the S&P 500's average duration for all 500 stocks is around 16–17 years (i.e., 1 divided by the turnover rate of 6%). Assume that the average duration of all 500 stocks is 15 years. Now, because the S&P 500 gives big firms more weight and small companies less weight, this time will differ for large and small companies.

According to estimates, investors hold large-cap equities for an average of twenty years, but smaller firms may be retained for around ten years. This implies that a large amount of what you think is long-term may only be retained for ten years on average. There are several more ways to construct an index that may decrease concentration, boost returns, and shorten the time it takes to double investors' wealth by raising the long-term average holding of S&P 500 components.

Perception of Risk

Larger, more well-known businesses with greater market capitalization often have lower turnover rates and longer holding periods because investors see them as less volatile and more reliable in the long run. Investors may hang onto their investments for shorter periods of time if smaller, less well-capitalized enterprises are more volatile and unpredictable.

Limited Exchange

Index funds and ETFs must purchase and sell units every day since the value of the S&P 500 fluctuates every day. Instead, because of the secondary market element of ETFs, there is more trading, which adds risk and noise for investors who believe that index funds are not traded much. These days, a significant portion of the underlying market's overall trading activity is made up of ETFs.

Equilibrium Delusion

When an index rebalances its weights, it implies that, in accordance with a predetermined methodology, the quantity of each stock or asset in the index is adjusted to ensure that the index continues to correctly reflect the market it monitors. The idea that passive market capitalized (MCAP) weighted indices don't rebalance is only a perspective. The S&P 500 MCAP approach is intended to rebalance continuously by increasing or decreasing component weights with each tick change.

A Slow Comeback

Indeed, the cost of passive funds is lower than that of active funds. However, just because Passive has a low cost does not guarantee that it will perform well. Additionally, compared to many other alternative ways of index building, passive is slower to recover once it enters a bad market and may stay in a bear market longer since it is less expensive and carries concentration risks. Many of the world's economies are still below their 2007 high, and this is mostly because the technique used to create indexes like the S&P 500 was designed poorly rather than because of economic growth.

Nowadays, the majority of benchmarks follow the S&P 500's 1871 methodology, meaning that they are either S&P-licensed or use a market-cap weighting technique of their own. All of them increase together, or remain in the red. Benchmarks have recovered from their respective peaks over an average of twenty years. Simple investors suffer greatly from the existing approach as they attempt to accumulate money and save. The passive methods used now aren't actually passive; they impede recovery and diminish return.

In summary

The existing passive will become clearer with a less focused approach that raises average long-term holding and risk-weighted outperformance. Because it is inflated during favorably trending periods and deflated during adversely trending times, today's passive isn't passive at all. There are other ways to reflect the market outside the S&P 500, which, as Irving Fisher first noted, is damaging long-term investors due to its bad design. Each year, tiny management costs and underperformance relative to a superior alternative to the S&P 500 cause passive investors to lose three to five percent of their capital.