Dumb Indexing

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


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.

search previous next tag category expand menu location phone mail time cart zoom edit close