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How is Your Index Fund Constructed?

How is your index fund constructed?

Passive index investing works, but not all indexes are created equal. Some of the most common indexes, such as the S&P 500, are heavily tilted toward growth stocks and away from value stocks.

Why should this matter to you? Three important reasons:

First, based on today’s valuations, growth stocks are historically very expensive compared to value stocks. Growth stock valuations are currently 33% above their long-term average, whereas value stocks are only 11% above that level. The price you pay for your investments matters, and higher valuations imply lower future expected returns.

Second, value stocks tend to perform better in inflationary environments. Inflation is currently hovering around 7%. While we don’t know how long high inflation will last, it is a real risk that investors need to consider.

Third, and perhaps most important, value stocks tend to outperform growth stocks over the long run. On average, they have outperformed growth stocks by 4.54% annually since 1928. This trend doesn’t hold true in all market environments, with the last decade being a notable example. If history is our guide, any investor that has a portfolio tilted toward growth stocks is likely to have lower lifetime returns.   

The most common indexes such as the Dow Jones, S&P 500, Russell 2000, and NASDAQ, are created by committees for purposes that are entirely unrelated to portfolio management. As the passive investing trend took off over the past few decades, these indexes served as convenient models for index funds. But the true benefits of index investing (lower portfolio costs as well as avoiding the stock picking and market timing errors of human fund managers) are entirely achievable with more intelligently created indexes. 

It pays to know what you own.

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