Do your homework before buying into index-based investments

Investment market indexes are probably not what you think they are. Two of the summer’s highest-flying stocks —Tesla and Apple — offer good examples of why you should understand what you own when you buy an index fund or when you compare your investments to indexes to measure performance.

Apple’s stock market value passed $2 trillion as its price grew by more than 70 percent year-to-date through the end of August. And yet, the most valuable publicly traded stock in the world declined from the largest holding in the Dow Jones Industrial Average to the 16th largest holding.

How can that be? The calculation of the value of the Dow uses a price-weighting strategy. The higher a company’s stock price (regardless of profitability or any other measure of company value), the more weight it carries in the Dow. At the end of August, Apple completed a 4-for-1 stock split that quartered its stock price and lowered its weight in the Dow formula. Apple will go from representing about 12 percent of the Dow to 3 percent.

Even before this quirk, the Dow wasn’t a very useful representation of the broad U.S. stock market. This is counterintuitive to people who hear the Dow price quote daily across media. The Dow includes only 30 stocks, each selected by a committee that periodically swaps companies in the index, as it did Aug. 31 dropping Exxon, Pfizer and Raytheon and adding Salesforce, Amgen and Honeywell. These 30 companies are meant to represent leaders of different industries but aren’t diverse enough to be an accurate indicator of the performance of the 3,000-plus publicly-traded U.S. stocks.

Tesla presents a different problem for indexes. Tesla stock rose over 500 percent from March 23 into August, lifting its market value into the top 10 of U.S. stocks. You might lament not having purchased this stock individually but at least you hold it in the S&P 500 Index fund in your 401k or IRA right? Oddly, no.

Tesla is not a member of the S&P 500 Index. It is being considered for inclusion, but the S&P 500 has quantitative and qualitative criteria that Tesla has not met, primarily four consecutive quarters of profitability. Tesla also is not in the Dow, but it is in the Nasdaq index.

The S&P Index Committee meets next on Sept. 18. There is speculation that Tesla will be added to the index soon.

These changes of membership help explain why indexes are often misunderstood and inappropriately used as comparative measures of investment performance. Among other misnomers, it is commonly assumed that the S&P 500 represents the largest 500 stocks in the U.S. This is not true either. For instance, Kohl’s is the 500th largest company in the S&P 500 at the same time that it was the 944th largest company by market value as tracked by the Russell 3000 Index, which is broad and holds stocks in order of market value.

For a purely quantitative measure of market size and position, the Russell indexes can be more useful than the S&P 500, Dow or Nasdaq. The Russell 3000 represents all but a fraction of the tiniest publicly-traded U.S. stocks. The Russell 2000 is the smallest 2000 stocks in the Russell 3000, the Russell 1000, the largest companies.

If you intend to compare your investment performance to the opportunity set of the broad U.S. stock market, the Russell 3000 is a good measure. Over the past several years, thousands of specialized indexes representing smaller slices of markets have emerged. Many specialty indexes are built to represent trading strategies rather than to be used as benchmarks or representations of a market. Some of these indexes slice markets into specific factors like dividend growth, momentum, profitability, industry sectors, and dozens of other characteristics.

Owning mutual funds or exchange-traded funds that track indexes can be simple, low-cost way for investors to build a diversified portfolio. There has been a massive shift in cash flow from investors moving away from professionally managed “active” funds to “passive” indexes that do not all seek to separate winners from losers among potential stocks or bonds that they buy.

When buying index-based investments, make sure you understand what the index represents in addition to its performance characteristics. Most indexes weight stocks by their size in the marketplace. The largest companies have the most influence on return and new investments are buying more of the companies that have performed the best. If momentum continues, this can be good, but it is not exactly buying with a preference for stocks that appear to be the best value. Of course, there are custom indexes that take qualitative measures of value, and risk, into account as well.