Index Distortions, Return Expectations, and the Investment Business   Dennis C. Butler, President Centre Street Cambridge Corporation Private Investment Counsel

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    of all guest columns written by Dennis C. Butler, CFA

The major capitalization-weighted stock indices have produced return figures so plagued by statistical aberrations that one is tempted to question their value as market barometers. Indeed, we note the increasing frequency of complaints in the financial press (not to mention among investment professionals frantic to explain their clients’ repeatedly poor results relative to "the market") that point to cases of extreme distortion in the averages. For example, in 1998 the S&P 500, which reported a 28.6% gain for the year, returned a much less impressive 2% when stripped of its fifty largest issues — a pattern typical of the popular market averages. Even more astounding is the fact that only eighteen popular issues accounted for all of the S&P’s 5.0% return in the first three months of 1999, when despite new index highs, most stocks declined. Investors who for whatever reason failed to embrace the biggest stocks or most popular sectors were very unlikely to do as well as the averages suggested was possible. In fact, most fared poorly in comparison: the average return for general equity funds last year was a gain of about 14.5%, and only around 1.0% in the first period of this year. Despairing of such results, many clients repaired to the apparent safety of index funds, and at least one filed a lawsuit. There are any number of possible explanations for this pattern of "underperformance" (changes in the composition of the indexes, for example). We thought it would be constructive to examine the phenomenon from a longer-term perspective, focusing on the problem with big stocks and their impact on the indexes, the investment business, and the investing public.

          First some perspective on the return statistics so often mentioned in the media reports we alluded to above: our Graph I presents the cumulative returns of the companies in the S&P 500 universe, on a value-weighted and unweighted basis, since 1981. The value-weighted figures correspond to the S&P as usually reported, where the results of companies with the largest market capitalizations have the greatest impact on the index’s overall returns. Unweighted returns are a simple average of the returns of all stocks in the index. They are themselves not free of distortions of their own, since outsized moves by a few stocks can unduly influence the average. Be that as it may, when viewed alongside the value-weighted figures, the simple average gives us some idea of the skewness of the former, due to the impact of the biggest stocks, that is not readily ascertainable in those results alone. Graph I, which includes the period of the current bull market, confirms that this has truly been a great time for the big stocks, relative to the broader market.

          Nothing new or surprising so far. However, Graph II, which merely extends Graph I a decade further into the past, may call into question the wisdom of extrapolating into the future even stable-appearing trends. An entirely different picture emerges: it seems the large-capitalization sector has not always dominated the market. In fact, this result holds true over several decades of returns. Very seldom have the large issues so strongly influenced our perception of "the market" as they have in the 1990s.
          Graph III offers further indirect evidence of the distortive impact of large capitalization issues over an extended period, as well as a dramatic illustration of their "relative strength" in recent years. The line represents the difference between cumulative value-weighted and unweighted returns calculated over ten-year periods ending in the years 1935-1997. In other words, a positive value indicates that value-weighted exceeded unweighted results; vice-versa for the area of the graph below the zero mark. It is clear that the domination of the capitalization-weighted S&P 500 market average by large-capitalization issues is a relatively rare event; as a matter of fact, the current period is really quite extraordinary in that respect (1998’s results would seem to indicate that the trend intensified last year). Therefore, to the extent that the popular indexes are reflecting a market anomaly, they are misleading investors as to what they can realistically expect from their stock portfolios.

          How did we get to this point, where investors appear to be precariously perched on a statistical outlier, and what is the impact? The market’s present affinity for big stocks owes its origin in no small part to the evolution of the investment business itself. The accumulation of investment capital into huge funds over the last two decades, for example, has fed the appetite for large, easily tradable securities. A good story doesn’t hurt, either: some of our largest corporations have been best positioned to benefit from the defining characteristic of the modern economy -- globalization -- making for an easy sale by Wall Street brokers. The move to indexing is another factor, as it automatically channels large amounts of money into those issues with the largest weightings in each index. Also important is the intense competition that has developed among investment firms for client assets -- competition predominantly based on short term results, or performance, relative to the market indexes. Competition on this basis inevitably forces investment managers to do what works (as opposed to consistently applying tested investment principles and policies), or risk losing business and their jobs. The process is circular: owning the large stocks has worked, so their prices are bid higher, attracting even more interest, and so on.

          But striving after "what works" affects the industry and its customers in important ways. For one, there is no logical limit to risk-taking -- even as the big stocks have risen to speculative price levels, they still have to remain on buy lists. Money managers have been shown to go to great, contorted lengths to keep up with the averages and beat the competition. For example, funds specializing in smaller issues have found ways to include large-capitalization stocks in their portfolios. Others have loaded-up on particular market-leading sectors, such as technology. Even supposedly conservative funds these days contain surprises like Internet stocks. Finally, the investing public, beguiled into thinking there is nothing unusual about the current period, that markets always go up and that owning the most successful securities is the wisest policy, never learn that, on Wall Street, it is not a good idea to do what everyone else is doing.

          Participants in this game do not question the rules because, so far, the trend has worked in their favor. Trend-following has worked because, well, because it has worked: the current state of affairs has held for a sufficiently long time to become perceived as "normal." But what happens if, as we believe, the trend -- in spite of its strength and duration -- is a temporary occurrence and the market indexes are not representative of investment reality? It seems almost as if the entire investment business, blinded to what has really been going on in the marketplace, has been led to risk capital on a few dozen stocks, oblivious to the bargains available elsewhere in the list, especially during the past year. More concern with careful and rational analysis, and less attention to winning the race, would have uncovered these opportunities for clients. Unfortunately, such attitudes do not win kudos on Wall Street.

          Actually, the fact that so many investment professionals have not done as well as the averages in this environment is encouraging, since it suggests that at least some are sticking with sound investment principles and not chasing fads. Sound principles consistently followed tend to win out in the long run. Investment based on sound fundamentals also implies that the practitioners take a longer-term view, understand that money cannot flow in one direction forever, and do not let themselves be beholden to buyers on the margin -- market players willing to pay the last inflated price for the favored few stocks. These investors may be suffering from relatively poor results now, but history indicates that they do well in the long run, and with less risk.

          In conclusion, the factors responsible for the distortions in the popular market indexes are intertwined with forces that motivate the investment business as it has come to be. Our portrayal of that business is, admittedly, harsh, but deservedly so -- some of its practices are potentially harmful to customer interests. Unfortunately, we can offer no easy remedies for the industry’s flaws or fixes for the problems with market indexes. Wall Street’s "performance derby" seems so firmly entrenched as to admit of no general modification. As for the indexes, some have suggested that new measures of market returns and valuation be devised, as none has as yet been able to meaningfully capture movements of the market as a whole. But we doubt that any sort of average, regardless of construction, would be free of the uses and abuses we described, since it would not address the industry’s structural weaknesses. As long as Wall Street insists on gauging portfolio returns precisely versus a benchmark, during intervals of three months or less, it will do whatever is necessary to "beat the market" (however defined) and the competition, in the process creating anew the types of distortions we seek to correct.

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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.

"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28).   "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:

Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139

Telephone: 617.441.9695

Email: cscc@comcast.net
URL: www.businessforum.com/cscc.html.

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