Thursday, December 10, 2009

Index Investing in the Context of Exposure to a Market

In last couple of years, Exchange traded funds (ETFs) as an investment vehicle has gained momentum among individual investors. In addition, we can also see never ending queue of new ETF based funds either being launched or waiting in the wings. There are few key aspects such as low expenses, trading ability during normal market hours, and relative transparency. Let us take an example of S&P500. We expect that buying S&P500 based ETF fund will provide us exposure to US economy.

  • S&P500 is market cap based index. The top 28 companies have 40% contribution to the index, while top 45 companies provide 50% contribution, and top 180 companies provide 80% contribution. As an investor it really does not help to invest in index hoping to have exposure to US economy.
  • In S&P500 index, the bottom 320 companies have only 20% contribution. As an investor, do I really need to be part of 320 companies for only 20% exposure?
  • The top 10 companies in S&P500 index (which have approx. 20% weightage) earn close to 40% of the revenue from foreign and/or emerging markets. If we take the full gamut of 500 companies, it is likely (and probably safe to assume) that more than 50% of the revenue comes from markets outside US. So as an investor it does not seem to provide exposure to the US economy.
  • The index consists for array of companies who weightage is based on market capitalization. In case of S&P500, the top 10 has a significant contribution to the index and it can sway it performance even with small change. However, a set of 10 companies on the bottom rung, will not impact S&P500. Even if these 10 companies are doing good and maintaining consistency performance, profitability, and good financial management, there will be no visible impact on the index. As an investor, the value of our investments will be at the mercy of large companies.
  • The index is an attempt to capture a wider base of business in the economy; it is difficult to have all good quality companies. Index will have good quality and bad quality companies. Even though we as an investor may not like a company, we get exposure to it by default.
This is quite intriguing. It may be good indicator for the economy and provide a ‘relative’ comparison tool in different time periods. However, as an investor, its applicability and use in our portfolio is limited to structure.

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