There has been much discussion about investment strategy. Is an active management strategy (where the investor or an investment manager actively selects the investments in the portfolio) or a passive strategy (simply trying to replicate a broad market index with selected investments) the better choice? Or does the best answer lie somewhere in between (a semi-active portfolio). Our attempt here is simply to discuss both. The ultimate decision lies with the individual investor.
Passive investing usually involves trying to replicate the performance of some broad market index. The S&P 500 is one of the most common stock indices. If one chooses the passive approach, one should know the characteristics of the underlying investment. For example:
- How well does the index represent the desired asset population?
- What is the criteria for inclusion in the index (i.e. the specific characteristics of the stocks desired in the index universe)?
- How are the stocks weighted in the index?
- What is the computational method used in the index (i.e. does the index represent only the price change in the included stocks or does it include dividends (total return))?
- Price Weighted- Each stock is weighted by its absolute price. A stock priced at $50 has twice as much weight in the index as a $25 stock. The index construction is relatively simple; however, there is obviously a price bias.
- Value (Market Capitalization) Weighted- Each stock is weighted according to the company’s market capitalization (the company’s price per share times the number of shares). The bias here is toward large capitalization companies. This bias can result in a less diversified portfolio concentrated in a relatively few companies. The S&P 500 is composed of the 500 US stocks with the largest market capitalization; however, the top 10 (2%) companies comprise about 17% of the index.
- Equal Weighted- Each stock is weighted equally in the index. In this case, small companies have the same weight as large companies.