Dumb Indexing

Earlier this year my friend Ben Carlson threw up these numbers on Twitter:

The S&P 500 now makes up 3 of the 10 largest ETFs pic.twitter.com/DeIC2O88XR

— Ben Carlson (@awealthofcs) January 6, 2015

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That is a lot of money in S&P 500 ETFs. It’s also a lot of money in iShares’ flagship international fund EFA, mimicking the MSCI EAFE benchmark.

The thing is, the S&P 500 and MSCI EAFE are not very good indexes for investors looking for broad market exposure. We often think that the S&P 500 represents the largest 500 US companies, but in fact it’s just 500 large US companies. The list of 500 stocks is driven by a committee that decides who makes the cut and who doesn’t. As a result, there is a good amount of turnover. Every year stocks are removed due to buyouts, mergers, reorganizations and financial struggles. A poor performing company whose stock is in the tank is likely to get the boot to make room for a newer, fast growing company. The best recent example of this is when Facebook was added in 2014.

In fact, Morgan Housel recently noted that the S&P 500 has historically been outperformed by the original stocks of the S&P 500! That is to say that the committee deciding which stocks to add and which to remove has done a poor job.

The MSCI EAFE is probably the most widely recognized international stock index. But EAFE, which stands for Europe, Australia and the Far East, is a limited sample of international developed economies. The most glaring issue is the absence of Canda. The MSCI EAFE has over 50% of its weighting in Japan, the UK and France alone.

So while an S&P 500 ETF and an MSCI EAFE ETF are, let’s say, pretty good investment vehicles, they are by no means the most efficient way to gain access to the markets. A total-market fund will have more holdings, broader diversification and lower turnover than a fund tied to these popular benchmarks. Index investing is good, but dumb indexing leaves room for improvement.