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  • Writer's pictureChris Mayer

Indexation And Its Discontents

Strange markets. And not just because of the virus, negative interest rates and the mind-boggling government stimulus. There is also indexation, which dominates money flows and creates its own distortions.

One man who has a lot to say about all this is Murray Stahl, the Chairman and Chief Executive Office at Horizon Kinetics.

I think Murray Stahl is one of the most interesting investment thinkers working today. And so I always look forward to reading his annual compendium of selected essays. I have the series going back to the 2014 edition, which was the first. (I think you have to be a client in some way to get these books). I have been reading these essays all week and they have stimulated a lot of thinking.

The official title of this year’s edition is “Compendium Compilation: Selected Essays Published in 2019.” It’s a fat 361-page book. As always, the essays range over a number of investment topics. A sampling of essay titles gives you the flavor: “Wide Moat Businesses and Their Vulnerabilities” “The Auto Loan Industry” “The Furniture Industry as Lower Risk Cyclical” “The Logical Consequences of Uber” and many more, including lots on crypto currencies and precious metals. If you follow Stahl at all, you also know one of his favorite topics is indexing.

Horizon Kinetics has dug more deeply than any other firm into the world of indexation. I find Stahl asks good questions, whether you agree with him or not.

Below, I share comments on a pair of essays in the middle of the book. (I put the date of original publication in brackets and have not updated any numbers cited in the essay).

“Firing the S&P500: How Indexes Are Invalidating One Another and Modern Portfolio Theory” (November 2019)

One of the questions Stahl asks in different ways boils down to this: Is the S&P500 a good benchmark?

Generally, American investors benchmark themselves against it. Consultants and advisors often judge a fund based on how it did against this index – usually on both return and volatility. By the lights of modern finance, volatility is a measure of risk. Higher volatility means higher risk. And higher risk should come with higher returns. So says modern finance.

Thus, the Holy Grail would be a fund that delivers a higher return than the S&P500 with lower volatility. I’m not agreeing with this, just saying this is the common view.

Well, there is such a fund – an ETF, to be exact. Stahl shows how the iShares Edge MSCI Minimum Volatility USA ETF (USMV) – boy, that’s a mouthful! – has beaten the S&P over the last 1-, 3- and 5-year period:

And it’s done so with about one-third the volatility.

Why bother owning the S&P500 when you can own a subset of the lower volatility stocks – and still earn a better return?

As Stahl writes:

“The USMV low volatility index beats the S&P500 in every time period since USMV was launched. If low risk actually can consistently outperform higher risk assets, this calls into serious question the logical foundations of modern portfolio theory.”

Indeed. The market seems to be catching on, though. Stahl points out that inflows to the largest low vol ETFs have nearly matched the inflows into the largest S&P500 ETFs.

Now, note the weirdness of this whole thing: The low vol ETFs are buying a lower volatility subset of the S&P500. It’s like a nested Russian doll. In theory, why couldn’t you just nest yet again – take the lowest vol stocks of the low vol S&P500 ETFs… “Then,” Stahl writes, “the even newer index would have to displace the low volatility S&P500 index, and so on, and so forth.” It’s like turtles all the way down! Where does it end?

Bizarre to say the least… Stahl says that either one of two things is true: Either you accept that low volatility stocks consistently outperform high volatility stocks --- which kicks out the legs from under modern portfolio theory… Or, you “conclude that the index movement itself is creating and influencing its own performance, and that would make these indexes invalid for use as benchmarks.”

Food for thought…

“The Bessembinder Study And Its Implications For ETF Investing”

(December 2019)

I remember when the Bessembinder study came out. It got quite a bit of play from Woodlock House and friends in internal emails…

Basically, Hendrik Bessembinder, a professor at Arizona State, published a study of equity returns that came to a startling conclusion: The vast majority of stocks (about 96%) didn’t beat the return of US Treasury bills.

Here’s the abstract:

“We study compound returns to nearly 62,000 global common stocks during the 1990 to 2018 period, documenting that the majority, 56% of US stocks and 61% of non-US stocks, under perform one-month US Treasury bills over the full sample. Focusing on aggregate shareholder wealth creation measured in US dollars, we find that the top-performing 1.3% of firms account for the $US 44.7 trillion in global stock market wealth creation from 1990 to 2018. Outside the US, less than one percent of firms account for the $16.0 trillion in net wealth creation.”

A link to the study is here:

As Stahl points out, of the 25,697 stocks in the sample, only 1,092 – about 4% -- beat Treasury bills.

How so? The study focuses on dollars of wealth creation, not return. According to the study, GM created $425.3 billion in wealth – bankruptcy notwithstanding. Berkshire created $355 billion of wealth; Apple, $745 billion. Note again, these are not returns. Berkshire’s return was higher, though it has created fewer billions than Apple as a public company. The study focuses on dollars.

On that measure, Exxon was the greatest wealth creator of all: over $1 trillion.

Stahl is much impressed with this study, calling it “a seminal piece of scholarship that provides insight into why managers underperform indexes.”

With the bulk of returns coming from a small number of securities, “it must logically follow that the index return is the result of natural concentration. In other words, the best stocks become the biggest positions in the fullness of time.” The index lets its big positions get bigger.

Bessembinder, then, provides an argument for letting your actively managed portfolio get unbalanced over time. Let your big positions get bigger. Based on the study, this may be your best path to topping the index.

The study also provides an argument against switching positions. “If 96% of the securities do not provide a return higher than Treasury Bills,” Stahl says, “then when trading one stock for another, one has a 96% chance that the new position will get a T-Bill rate of return. The Bessembinder study is the best argument for long-term buy and hold investing that I have seen.”

More food for thought…


I have a bias against index investing, no surprise. Yet, sometimes I find it hard to articulate why. I don't like the price insensitive, indiscriminate buying of stocks just because they are in an index. It seems unwise.

On the other hand, I find it hard to argue against the results. The S&P500 has been a tough index to beat consistently.

But there are contradictions and problems with index investing, which Stahl explores. I don't know how these things will ultimately play out. (Steve Bregman, president of Horizon Kinetics, flat out calls indexation a "bubble" in his introduction to Stahl's book). Nonetheless, they do provide food for thought about the nature of investing and benchmarking, among other topics.

Anyway, I hope the above made you a think. Thanks for reading and enjoy your weekend!


Published April 17, 2020

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