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Passive investing and the impact of index decisions

12th January, 2021

Passive investing is seen as a way of “buying the market”. However, investors should be aware that decisions around stock market indices can have a dramatic effect on what that “market” is.

IBM in the Dow Jones Industrial Average index

In 1939, long before passive investing was practiced by investors, the Committee that selected the members of the Dow Jones Industrial Average (DJIA) index took the decision to remove IBM and replace it with telecoms firm AT&T. IBM was subsequently restored to the index 40 years later in 1979 after its share price had increased by c. 22,000% compared with just 149% for AT&T over the same period.

The impact of this decision can be seen in the fact that the DJIA would have reached a level of 23,582 by June 1979 had the Committee not removed IBM in 1939 rather than the actual level achieved of 841.

Impact of index composition on passive investing

While this example is somewhat extreme, and the DJIA is not an index which is widely tracked by passive investors, it does highlight the impact from the often arbitrary and subjective decisions around how stocks are included in market indices. The influence of index providers and their role in determining how savings are allocated has increased greatly in recent years due to the rapid growth of passive investing.

While the ongoing management of these assets can be broadly described as “passive”, the composition of the indices being tracked is the result of active decisions. Membership of the main market indices is typically determined by an index committee that makes decisions around the rules that determine which stocks to include and exclude.

Tesla & Salesforce.com

There are two recent noteworthy examples that highlight the impact of these types of decisions. The first is the decision of the S&P Index Committee to add Tesla to the S&P 500 effective from 21st of December 2020. It was estimated that approximately $100bn of demand for Tesla shares was created due to the c. $11 trillion of passive assets that track the S&P 500 index. These passively managed assets must hold Tesla shares in proportion to its weighting in the S&P 500 in order to match the index returns. As a result of this Tesla shares rose by 40% in the two weeks following the announcement by the S&P Index Committee. While the outlook for Tesla is widely debated, the company is being added to the index after having reached a market capitalization of over $600 billion after its share price rose by over 700% in 2020. 

The second recent example is the removal of Exxon Mobil from the DJIA index after being included in the US bellwether index continuously since 1928. In August of this year it was reported that the index committee would be replacing Exxon Mobil with Salesforce.com. This change does not have a material impact in terms of asset flows compared with the decision to include Tesla in the S&P 500 given that the DJIA is not a widely tracked index. However it highlights how passive strategies have an inherent bias towards those stocks with higher valuations due to both the market-cap weighted methodology of how indices are constructed and also the frequent addition of stocks that have performed well (in this case Salesforce.com) at the expense of underperforming names (Exxon Mobil).

Summary

At Davy we invest our clients’ assets in both active and passive strategies. We believe that investors’ interests are not well served by making definitive, absolute statements around whether active or passive is best in all cases. We assess the merits of each approach on a case by case basis when we seek to gain exposure to a specific asset class or market.

There are markets that are more challenging for active managers where we recommend a passive approach. We are also aware that a passive approach incorporates active decisions on the part of an index provider and in many cases these decisions can lead to passive solutions having greater risks than actively managed options. We believe that having a deep understanding of the pros and cons of each approach depending on the circumstances represents the optimal approach in managing our clients’ assets.

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