Smart Indexing is becoming a more widely accepted investment strategy.
Instead of following a market cap weighted approach to indexing like the S&P 500 index does, Smart Indexing strives to have a more balanced weighting across all sectors, sizes, and styles. It is a so-called ‘smart beta’ strategy designed primarily to increase diversification.
In a capitalization-weighted index, the weight of each stock is equal to the total value of the company divided by the total value of all the companies in the index.
With the market capitalization-weighting approach, there are two big problems:
Problem #1: Automated buying high and selling low.
This is the opposite of what you want. If a stock is overpriced in the market, owners of capitalization weighted indexes will own more than the “fair value”. Conversely, if a stock is currently undervalued by the market, it will be owned at a lower amount than “fair value” would suggest. So as prices revert to long term fundamental values, these indexes suffer.
Problem #2: Large Random Bets increase Volatility
If you own a capitalization weighted index fund, you are taking big bets on whatever stocks and sectors happen to be big, for no reason other than the fact that they are already big. This can increase volatility and risk.
The below chart demonstrates equal 10% weightings in 10 US sectors. If you were to follow the S&P 500 index as a benchmark for performance, you would be overweight Technology, Financials, and Health and significantly underweight Communication, Materials, and Utilities. You might think that being overweight Technology is a good idea because it’s a higher growth sector than the Utilities sector. However, you never know when the hot sector may turn cold.
The below chart demonstrates equal 10% weightings in 10 US sectors. If you were to follow the S&P 500 index as a benchmark for performance, you would be overweight Technology, Financials, and Health and significantly underweight Communication, Materials, and Utilities. You might think that being overweight Technology is a good idea because it’s a higher growth sector than say, the Utilities sector. However, you never know when the hot sector may turn cold.
Slide 1:
Exposure to “momentum” categories in bull markets can be huge. If your portfolio was invested in the S&P 500, you held an estimated 29% weighting in Technology in 1999. That means almost a third of your portfolio was in a single sector. The same goes for Financial stocks in 2006. Financials made up 22% of the S&P 500 before the credit crisis. Sector bubbles can crop up in every index, not just the S&P 500.
In addition to equal weighting sectors, Smart Indexing also takes a more balanced approach to size and style. Small, mid and large companies are represented more equally. Similarly, allocation across growth, core and value stocks is more even.
Personal Capital supports the strategy of Smart Indexing because we believe it provides a better risk-adjusted return on investment. There’s research that shows how equal-weighted indexes perform better than market cap-weighted indexes. Based on our back-testing of a $500,000 portfolio that began in 1990, one would have $1,576,588 more in their portfolio using a Smart Indexing approach vs. a market cap weighted approach.
If you work with a Personal Capital advisor, they will come up with the best financial strategy to suit your needs. They will also help you diversify across multi-asset classes, dynamically rebalance your portfolios, and tax optimize when appropriate. Click here to sign up for Personal Capital’s free financial dashboard and request to speak to an advisor today.
Disclosure: The Tactical Weighting Strategy shows hypothetical index results, and does not reflect an actual account or trading. Nor does it reflect the impact of fees and expenses that would be incurred by a managed account or fund attempting to follow an indicated index strategy. It is not possible to invest directly in an index or strategy without fees and expenses. Based on available data, the hypothetical results are time linked equal returns of size, style and sector indexes. From 1991 to 1995, it is an average of equal weighted S&P sectors and an equal weight of the S&P 500 and Russell 2000. From 1996 to 2011, it is an average of equal weighted S&P sectors and the nine Russell Style box indexes. Standard deviation is only inclusive of full year return figures. Results assume the reinvestment of dividends. Past performance is no guarantee of future results. Transaction costs, management fees, taxes and other factors, all of which would impact returns, are not considered in the analysis. It is not possible to invest directly in an index or strategy without incurring fees and expenses. All investments involve risk of loss. There can be no assurance that any strategy will be profitable, or that the portfolios described above will perform better than the S&P 500 or other market-weighted index. Actual Performance: Actual Result is performance for our Tactical America strategy, a US equity only strategy. For the calculation, 2012 results were calculated as an average of actual client portfolio returns within the strategy. Only accounts trading for the full calendar year with no material additions or withdrawals were included. For the composite, returns are derived by linking respective quarterly returns. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Performance is shown net of fees and reflects the reinvestment of interest and dividends. Accounts in the composite are billed on a tiered fee schedule and larger
accounts generally pay a lower overall fee rate than other accounts. Accounts with greater than ten percent individual custom restrictions resulting in greater than two percent difference in performance results were not included. Individual account performance will vary depending upon the amount of assets under management and the timing of any additions and withdrawals and may be higher or lower than the performance depicted. [Advisory fees for the accounts included in the performance data ranged from annual rates of 0.75% to 0.95%, depending on the size of the account. Performance for employee and other affiliated accounts has been recalculated to reflect the standard fee schedule rather than the discounted fees paid by some of those accounts.
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