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An Easy Way to Lose 10%

August 25, 2016
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Imagine the following scenario:

You want to travel down river with the goal of matching the river’s average rate of flow. You can choose from 5 different vessels – a yacht, at fishing boat, a canoe, a raft or an inner tube. If you wanted the river’s average rate of flow, which one of these vessels would represent that average rate, or index? The answer, of course, is none of the vessels would represent the index because in this example, the index is the river, not the vessel.
Depending on the condition of the river, some vessels would prove a better choice than others. If waters were relatively placid, a motorized fishing boat would likely get you to your destination faster than a manual powered canoe but should waters become choppy and large rocks impede progress, a motorized fishing boat would prove catastrophic while a canoe would navigate without incident.

Such is the case when deciding to invest through indexing. It is difficult if not impossible to truly mirror the index because regardless of how much you would like to mimic the average, each method of indexing requires the investor to choose the method, or “vessel” with which to participate in the index.

For example, if you are an S&P index investor, you are deciding:

  1. To own ONLY the top 500 large cap domestic companies despite the fact that there are many more times that amount of large cap companies in existence.
  2. To own a higher percentage of the larger sized companies rather than a more equal weighting.
  3. To rebalance the company weighting once every quarter rather than on a more frequent basis.

This manner of participation differs from other index choices which may use in excess of 1,000 companies, or may purchase a more equal weighting of the companies or even rebalance with greater frequency.

A better way to index would be to ask yourself the following question: Why do I want to index? Someone who invests in large cap companies because of the lower volatility compared to mid or small cap companies may want to consider investing in a low volatility ETF or mutual fund. However, in our opinion, if the preference is towards dividends an investor might be better suited for a dividend paying ETF or mutual fund.

The point here is simple. Since there is no way to truly index, or get the same return as the desired asset class, time must be spent to determine which ETF or mutual fund is most suited to provide the type of participation the investor has in mind. Few things are more frustrating to an index investor than discovering that their investment choice remained flat while the index appreciated.

In conclusion, the manner in which you chose to participate in the index can be equally if not more important than your decision to index in the first place. As of this writing, choosing the wrong large cap vessel could cost you as much as 10% even though you are traveling down the same river. Bon Voyage!

By J. Thompson
Managing Director
Domari Wealth Management

The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Private Wealth Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results. All investments involve varying levels and types of risks. These risks can be associated with the specific investment, or with the marketplace as a whole. Loss of principal is possible.