Many active strategies have fallen short of their benchmarks and passive exchange traded funds over the years as simple and concise indexing rules help keep index-based strategies on track.
Over the past five years, only 21% of active mutual funds have outperformed their benchmarks, reports Julie Verhage for Bloomberg.
Consequently, investors have funneled billions into low-cost, index-based funds that try to passively reflect the performance of the benchmark indices.
For instance, the S&P 500 index now has $7.8 trillion following it with $2.16 trillion of that coming by way of exchange traded funds, mutual funds and other investment products. The largest S&P 500 ETFs include the $178 billion SPDR S&P 500 ETF (NYSEArca: SPY), the $69.2 billion iShares Core S&P 500 ETF (NYSEArca: IVV) and the $32.6 billion Vanguard 500 Index (NYSEArca: VOO). [There’s $7.8 Trillion Benchmarked to the S&P 500]
According to Morgan Stanley, one of the main reasons why the S&P 500 benchmark is outperforming active strategies is because of the S&P 500’s indexing methodology. Specifically, the S&P tends to remove companies and add others that typically outperform.
“The median stock removed from the S&P 500 has negative earnings growth in the preceding three and five year periods,” Morgan Stanley analysts said in a note. “The earnings growth of the companies added to the index was not only much superior to the companies removed but also much higher than those companies already in the index.”
Consequently, the benchmark reconstitutions create an important upward bis in the earnings growth of the S&P 500 index. The analysts calculated that the difference in the year-over-year earnings growth rate of the S&P 500 using all the stock sin the index, compared to the growth rat eof the index excluding new entrants, revealed a median annual gap of 1.2%. Additionally, the regularly reconstituted index outperformed an index excluding new entrants for eight consecutive years.
“The new companies that are added to the index typically have much higher margins than both the companies removed and the surviving constituents …with faster prior revenue and earnings growth, and higher margins, the stocks added to the index typically have performed much better over the few years before their inclusion,” Morgan Stanley said.
While index-based ETFs may passively reflect a benchmark, there is some active component in the underlying indices that could bolster growth. In the case of the S&P 500, the index trims companies with poor earnings per share growth but adds more quickly expanding businesses.
For more information on index-based funds, visit our indexing category.
Max Chen contributed to this article.
Full disclosure: Tom Lydon’s clients own shares of SPY