Shownotes
Welcome to episode 73 of the One for the Money podcast. I am so very grateful you have taken the time to listen. In this episode, I will share why investors should look beyond investing in just the S&P500.
In the tips, tricks, and strategies portion, I will share a tip regarding mutual fund and ETF management fees (also known as expense ratios).
In this episode...
- Cost Considerations [2:39]
- Growth Limitations [4:55]
- Diversification and International Exposure [9:49]
Years ago, I spoke with a gentleman who had his own company. He learned I was a wealth manager and expressed his frustration that the advisor who was managing his company’s 401k plan had made some poor predictions about the economy and consequently grossly underperformed the stock market. He then asked me an interesting question: why not just invest everything in the S&P500 and be done with it?
This gentleman isn’t the only one with that same question and some, in fact, follow this philosophy by investing only in the S&P500 believing it is a wise investment strategy. Here are several significant reasons why investors should look beyond investing in just the S&P500.
But first, it must be noted that the possibility of this discussion is entirely thanks to the pioneering work of Jack Bogle of Vanguard. He deserves so much credit for what he accomplished in ensuring people could invest in passive index-based funds. Before him, you couldn’t inexpensively invest in the 500 stocks of the S&P500. There wasn’t an option, but because of the index funds he created, he made it possible to do so incredibly inexpensively. It will cost you just $3 a year for every $10,000 to invest in the 500 companies of the S&P500 index. That is remarkable.
Now many think one can solely invest in the S&P500 and be done with it. But historical analysis has shown that there are compelling reasons to invest in more than just the stocks listed in the S&P500.
Indexing vs Indexing plus
The first reason is that investing in an index can actually be more expensive. Many think it is a really inexpensive way to invest and from a cost of management perspective, it is. But you have to consider more factors than just the cost of management. I’ll explain. The S&P500 is an Index. An index is just a publicly available list of stocks. It’s sort of like an investment recipe. But unlike grandma’s tried and true chocolate chip cookie recipe, the “ingredients” of the S&P500 change from time to time. In a dynamic capitalist-based economy, companies grow bigger and others grow smaller. This requires changes to be made to the list of stocks, or in other words, changes to the investment recipe. And whenever changes are made to the index, it’s announced so everyone knows the stocks that will be added, the stocks that will be removed, and the date when it will happen. Consequently, everyone knows what all of the indexes are going to buy and sell. As one can imagine the costs can increase as a result. There are passive investment strategies, like factor investing which I featured in episode 68, where they employ more flexibility in what they buy and sell. Buying stocks whenever one else is, is a lot like buying roses on Valentine's Day. It’s a more expensive way to buy both roses as well as stocks.
We have a very recent example. On September 6 of this year, 2024, it was announced that the company Palantir would be added to the S&P500 Index starting on Sept. 23, 2024, and you will never guess what happened, The stock rose 13% in the next trading session. By the time all of the indexes add this stock to their investment list, the price of the stock will likely be much higher. That’s an expensive way to buy stocks.
Another reason why the index can be more expensive is because they only buy and sell a few times a year when the changes are announced. The S&P 500 rebalances on the third Friday of March, June, September, and December. This process involves changing the weightings of companies in the index and sometimes adding or removing companies. That can lead to buying stocks at higher prices. But with other types of passive investing, it allows managers to buy and sell every day the market is open and take advantage of more favorable prices.
Large cap vs small cap
The second reason why the S&P500 index isn’t necessarily the best option is because it only represents the largest companies in the United States, namely those with a market capitalization of at least $10 billion. You might think that’s a good thing but it’s wise to remember that every company started out as a small one. Amazon and Apple and Microsoft are what’s called MegaCap companies because they have a valuation of over $200 billion. In fact, Apple and Microsoft have a larger value than the GDPs of Canada, Russia, or Spain. But at one time Amazon, Apple, and Microsoft were operated out of a garage or small office and would then grow to become small publicly traded companies and later mid-sized companies, then large companies, and now mega-sized companies. By investing only in the S&P500 you missed out on the most significant aspects of their growth. Take Shake Shack vs McDonalds. When it comes to investing, you want the company you are investing in to grow rapidly and smaller companies will grow faster. Shake Shack from a percentage perspective will be adding a lot more restaurants than McDonalds will. That doesn’t mean we don’t invest in McDonalds and larger companies. In fact a good amount of my and my clients’ investments are invested in large companies, however, we also have a good amount invested in smaller companies because that’s where the most explosive growth can occur. But if people only invest in the S&P500 you are only investing in the American companies after they got really large and you will miss out on buying the Apples, Teslas, Nvidia, and Microsofts when they were smaller. Again, using Palintar as an example. In the two years prior to joining the S&P500, the stock soared 350%. Those who invested in mid/small caps could have enjoyed that growth but those who solely invested in the S&P500 missed out on all of it.
To further my point as to why investing in small company stocks is important. For the period between 1926–2016, the compound annual growth rate of return was 11.4% for the Small Company Index and it was 10.0% for the Large Company Index. That may not seem like a significant difference but over that 90-year period, $1 invested in small caps would have grown to over $20,000 where as $1 invested in Large cap would be just over $6k. And since 1927 through December 2023 small stocks outperformed large stocks and 68% of the time after 10 years.
Another reason to invest beyond the S&P500 is because of valuations.
Some stocks are more expensive than others. Confusingly, this has nothing to do with the price of the stock but rather the price of the stock relative to the earnings of the company. This is known as the P/E ratio. Companies for which you pay a higher price for earnings are called a growth stock whereas companies for which you pay a lower price for earnings are called a value stock. The difference can be significant. Historically, value stocks have outperformed growth stocks in the US, often by a striking amount. Data covering nearly a century backs up the notion that value stocks—those with lower relative prices—have higher expected returns.
The S&P500 at times has become overvalued and some of that overvaluation can be concentrated on growth stocks. For example, in September 2024, the top 10 companies of the S&P 500 are 36% of the index. That’s right 2% of the companies make up 36% of the value.
And as of July 31, 2024, the top 10 companies had a price-to-earnings ratio of 31.4 times earnings whereas the bottom 100 had a ratio half that, 15.3%. No one can predict where the market goes from here but historically growth stocks at these high valuations tend to come back to earth. In fact value stocks have outperformed growth stocks by 4.4% annually in the US since 1927. Since 1926 through December 2023 value stocks were higher than growth stocks 70% of the time after 5 years and 78% after 10 years.
Another reason to look beyond the S&P500 is it doesn’t focus on a company’s profitability. That may seem like a captain obvious type comment but factoring in companies with higher profitability can make a significant difference for investors. Since 1963 through December 2023 high profitability companies were higher than lower profitability companies, 67% of the time after one year, 82% of the time after 5 years, and 92% of the time after 10 years. The S&P500 doesn’t always reflect the most profitable companies.
Domestic vs International
A final reason to invest beyond the S&P500 is because you miss out on investing in great international companies. The S&P500 is composed of solely large American Companies, but there are a lot of great companies beyond our nation’s borders. Some of those companies reside in more developed countries such as Great Britain, France, Taiwan, or Japan while other up-and-coming countries, defined as emerging market economies have great companies as well.
An additional reason to consider international stocks is sometimes they zig while the S&P500 zags. In fact there was a period of time where an investment in the S&P500 was down 9% after ten years. so if you had invested $10,000 in the S&P500, ten years later your investment would have been worth just shy of $9100 dollars. That’s a poor return after 10 years time. That period of time was from January 2000 to December 2009. January 2000 was the height of the dot com/dot-bomb era and December 2009 was during the global financial crisis aka the Great Recession. How did international stocks during that time perform?
The MSCI International index that excludes the USA, returned over 17% during that time, the MSCI International value stocks index, returned over 48%, the MSCI International small cap index returned over 94% and the MSCI International emerging markets index and emerging markets value index returned over 154 and 212% during that same Jan 2000-December 2009 time period. As it’s often said, past performance cannot predict future performance but history has shown that it can help if you invest internationally.
In summary, an S&P500 fund can end up being an expensive way to buy stocks because it’s like buying roses on Valentine’s Day. The S&P500 fund also misses out on the faster growth of small and mid-sized company stocks, an S&P500 fund can become over-concentrated on Growth stocks, doesn’t emphasize the most profitable companies and finally, an S&P500 fund excludes good international companies. For these reasons, investors should look beyond investing in just the stocks of the S&P500 which me and my clients do.
Tips Tricks and Strategies
Welcome to the tips, tricks, and strategies portion of the podcast where I will share a tip regarding investment fund management expenses. Nothing in life is too good to be free and the same goes for the management costs of mutual and exchange-traded funds. Now mutual and exchange-traded funds are a fantastic way for you to spread your money across as many investments as possible with the least expense incurred. It’s the most cost-effective way to obtain diversification of your investments which is one of the of the bedrock principles of sound investment strategy. It’s based on the modern portfolio theory which ensures that you achieve the maximum return for the least amount of risk. Think of the unfortunate individuals who had all of their retirement or investment funds in a company that was found to be fraudulent. Enron being a prominent example. Those who failed to diversify outside of the company stock ended up losing everything.
As I noted earlier in this episode Jack Bogle, the founder of Vanguard, has mutual funds with exceptionally low management costs. Now the term used to describe these management fees is “expense ratio”. And with some mutual funds, the expense ratio can be as low as 0.03%. That’s just $3 a year for every $10,000 you invest.
Some mutual and exchange-traded funds have much higher management costs or expense ratios as they reflect additional costs involved. For actively managed funds you are paying for the investment managers, research, and marketing teams. For other funds, you are paying for the type of investments within the fund which may have a higher cost associated with acquiring them.
Most people aren’t aware of this internal expense but it is important to assess your investment portfolio management expenses to ensure you are getting value for them. The investment portfolios I build tend to have an average management cost of 0.2 to 0.3%. So $20-30/year for every $10,000 invested which allows for exposure to small and mid-sized companies, highly profitable companies, value companies, and international companies. However, I’ve seen some mutual funds for clients as high as 1.89%. That’s $189/year for every $10,000 invested. This fund was in a client's retirement plan at his former employer. What was worse was that this fund had massively underperformed similar passive mutual funds, which would have cost him just $3/year. Now what was really disappointing about this expensive active management fund is that it was from the very same provider as the company 401k retirement plan. Was there a conflict of interest? I can’t definitively say but it certainly doesn’t look favorable.
When I help clients with rollovers I always assess their current investments to see if they are invested in accordance with sound investment principles and in alignment with their goals. I also assess a number of factors. Such as the region, are allocated to just the United States or are they also allocated to international and emerging markets, which have proven through evidence to provide higher risk-adjusted returns. I also look to see if they have too much allocated to one sector such as healthcare, energy, or technology), and what about the size of the companies. Do they have too much allocated to small companies or large companies? I also look at their performance ranking against other similarly categorized funds. I’ll look at one large US company fund vs another large USA company fund. I also look at the fund expense ratios. As I mentioned I saw some of the fund expense ratios, for actively managed funds to be as high as 1.89%. What’s worse is that this fund had far inferior performance to the same category of passive investment funds that would have cost way less. Of course, past performance is no guarantee of future returns, and fund performances can come and go but fund expenses are forever.
All in all, it’s important that you are aware of many of the aspects of your investments including the associated expenses because they can have a significant impact over the course of years and decades on your ability to build wealth.
EXTRA
If you are invested in mutual or exchange-traded funds, which you likely are in your 401k, you are paying these fees, you just may not it. that’s totally normal, as most people aren’t aware that there is an internal management expense called the expense ratio. This is the fund paid to the mutual or ETF fund provider to assemble, manage, and market the fund. This fee covers the costs associated with the administration, portfolio management, marketing, and more. These are usually percentage-based and represent the cost each year. So they can be as low as 0.03%. To give you an idea how much a fee that would be. On $10,000 invested, it would cost you $3/year. Pretty great deal. But I’ve seen some funds paying as much as 1.89%. That would be $189/year. Now these fees are deducted internally. Why are these funds even necessary? Mutual funds and ETFs provide the most cost-effective way to spread your money across investments. The technical term we use for this is diversification. It's one of the most critical aspects of investing. It helps ensure that all of your nest eggs are in more baskets. This isn’t just age-old wisdom but rather based on evidence-based research proving that diversification is better for investors. The theory is called the modern portfolio theory and it is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. In layman’s terms, you get the highest potential return for the level of risk you are taking. That’s important because it doesn’t make sense to take more risk if you won’t be getting a higher potential reward. It would also be bad if you accepted a potential lower return but took on more risk.
This makes sense if you don’t have all of your accounts allocated to a single stock like they did with Enron when the stock cratered.
Mutual funds and Exchange-traded funds allow you to spread your money out. You couldn’t do that on your own. One of the best-performing stocks is Berkshire Hathaway. A single A class share of stock is over $680,000 as of this recording. That’s right, it’s over $680,000 for a single share. There is a B share that trades for just over $45o but even at these prices, $1000, $5000, or $10,000 won’t buy you many shares in different companies. That’s where mutual funds and ETFs come in to make it way more affordable to spread across small amounts over hundreds and thousands of companies.
The amount of the expense ratio is based on how much management you are going to have. Some are called Actively managed and what we mean by that is there are portfolio managers and research teams that are determining which company stocks are best to invest in. Some funds are passively invested and are invested based on a publicly available list. Like the S&P500 or DJIA. An actively managed fund may not select all 500 of the S&P500 but will select 258 that they think will outperform. Passive have very low expense ratios because little management is required than active. There is a lot of debate as to whether passive is better than active. You might think that active management with their research and expertise would have a clear advantage but long-term data shows otherwise. But long-term data shows otherwise that passive will outperform active over the longer term especially when you account for the fees. While there is certainly a place for active management in certain situations, a diversified passive investment strategy used in conjunction with a financial plan can serve you well.
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