Broadcast Retirement Network’s Jeffrey Snyderdiscussesactive vs. passive investment management with Francis, LLC’s Michael J. Francis.
Jeffrey Snyder, Broadcast Retirement Network
Mike, it’s so great to see you. Thanks for joining us this morning.
Michael J. Francis, Francis, LLC
Oh, my pleasure. Thanks for having me, Jeff.
Jeffrey Snyder, Broadcast Retirement Network
And I hope you’re staying quite warm in Wisconsin right now. I don’t envy you, although it’s cold, but not relatively speaking to what you have in Wisconsin. It’s cold here in Charlotte, North Carolina.
But again, thanks for making some time. I really enjoyed your article. As we discussed in the virtual green room, there’s been a lot of conversation over the years about active versus passive investing.
And they all have their pros and cons. And a lot of people have said a lot of things. But I want to ask you for your perspective, because I think your take is rather unique.
There is a case to be made for active management.
Michael J. Francis, Francis, LLC
Oh, there certainly is. And again, you have to be specific about the category, the asset class that you’re talking about. Because when people talk about index investing or passive versus active, they’re almost always talking about the S&P 500.
And therefore, the conversation is rightfully focused on the S&P 500 as an index versus a basket of professionally managed large cap US equities. But as you and I both know, there are a plethora of asset classes out there. And in some cases, the data shows the absolute opposite that the average actively managed fund outperforms the index.
So it is very important. When you talk about active versus passive that you specify about which index and about which asset category, asset class that you’re referring to. But the article that I wrote was specifically about the S&P 500 and large cap US stocks.
Jeffrey Snyder, Broadcast Retirement Network
And I agree. I think diversification matters. And there are, to your point, asset classes.
And you’re the expert here. But asset classes that maybe the active manager can find value.
Michael J. Francis, Francis, LLC
Absolutely.
Jeffrey Snyder, Broadcast Retirement Network
Think about maybe emerging markets.
Michael J. Francis, Francis, LLC
The less efficient the market, the easier it is for experts to capitalize on those inefficiencies and add value.
Jeffrey Snyder, Broadcast Retirement Network
Let’s talk about the S&P 500 because that was kind of the core of your article. Again, I don’t want to get ahead of you. But that is a bag of stocks, an index of 500 companies.
What should people know about the S&P 500 that maybe they see it on the news, they hear about it in a local paper or read your article? What should they know about an index like the S&P 500?
Michael J. Francis, Francis, LLC
I think there’s a couple of things that are widely misunderstood about the S&P 500. Yes, it is a basket of 500 companies. However, when they go to calculate the daily return of that basket of companies, they weight each company based on its market value.
So what would it cost to buy all the shares outstanding of the company? The larger that number, the bigger the weight that company gets within the index. And so you have what has developed recently, let’s say the last five to 10 years, a small group, some people call it the mag seven, that have just ballooned in asset value.
And therefore, when it comes time to calculate the daily return of the index, have a disproportionate amount of weight in determining that return. And really for the last three, four years now, it’s been 20, the top 20 names in the index, making up over 70% of that index return. So in other words, the other 480 are making up this very small portion of the return.
And that is surprising, I think, to a number of people. The second misunderstanding about the index is the fact that it is constantly changing. That this, yes, this is 500 stock, but companies go out of business, companies get bought and merged.
For all different kinds of reasons, they are changing this list of companies. And on average, it’s 25 to 30 companies a year disappear and get replaced. But there’ve been years when it’s been as high as 60.
Companies that have been replaced within the index. So it is somewhat of a moving target. And that is where the active part of a passive management comes into play, where the folks at S&P are constantly serving the landscape of public companies and saying, okay, which represent or which are the best representatives for the US economy?
And as I mentioned in the column, a lot of people are surprised to find out that when a very large, well-known company by the name of Enron went out of business about 20 years, 25 years ago. And all the folks at S&P get together and say, okay, that company just filed bankruptcy. What are we gonna put in its place?
They selected a very small manufacturer of game semiconductor chips called NVIDIA. In 2001, NVIDIA was added to the S&P 500. So if you’ve owned that index over that period of time, you’ve participated in arguably one of the greatest home run investments in modern times.
Jeffrey Snyder, Broadcast Retirement Network
Well, and just to kind of follow through on that, I mean, I’m not an expert on investing. Many people watching the program or listening to the program are not investors or sophisticated investors. Maybe they think they are, but they’re not because they have other jobs.
This is the value. Let’s talk about the value of a financial advisor or someone to assist somebody. There’s a value there that someone like yourself brings.
It’s not as simple as set it and forget it. To quote our friend, Ron Popeil, there’s value that you bring as a financial advisor to the relationship with a client.
Michael J. Francis, Francis, LLC
Absolutely. And I think we’re gonna see this in spades in the not too distant future. When the S&P, which is now concentrated, about 40% of the value of the S&P 500 today is concentrated in 10 stocks.
And those 10 names are virtually all technology-related companies. And it’s somewhat of a virtuous cycle that those companies perform well. And because they make up such a big piece of the index, that means the index does well.
That attracts money from investors that go into predominantly those same 10 stocks, which cause them to do better. So it’s this virtuous cycle that propels those companies higher in value and therefore propels the returns higher in the index. Whereas the same thing does become a vicious cycle on the way down.
When people get panicked, they’re nervous and start selling their index products, their index funds, the bulk of that money is coming out of those 10 companies. And that hurts the result of the index, which causes more people to wanna sell. And again, it accelerates it in the opposite direction.
So what we’re talking about now is an index which is much less diversified than, quite frankly, the S&P creators themselves suggest that they’re offering investors. And I don’t think most investors are aware of this. And so what we counsel long-term investors is to think, okay, if you’re an index person for large cap US, it’s a really solid decision to make, but you have to have the emotional stability to withstand the inevitable 30, 40, or even 50% pullback that historically this index has delivered when the selling cycle begins.
And that’s where having a professional advisor can be helpful because they can hold your hand and tell you everything’s gonna be okay and remind you that this is a long-term game we’re playing, not something that we have to worry about month to month or even quarter to quarter.
Jeffrey Snyder, Broadcast Retirement Network
Yeah, I kind of liken it to your accountant, your lawyer, or your trusted advisors. You need someone, and sometimes you need someone to hold your hand and counsel you and remind you because we all have emotions. Mike, I wish we could spend a lot more time, but that just means we’re gonna have to bring you back.
Again, thanks so much for joining us this morning. Really appreciate your analysis, and we look forward to having you back again very soon.
Michael J. Francis, Francis, LLC
My pleasure, Jeff. Thank you for having me.