Danger Zone: "Passive" Investors

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and MarketWatch.com.

Passive investors are in the Danger Zone for not recognizing that they are actually active investors.

Unless you are investing in the whole market—e.g. the Vanguard Total Stock Market ETF VTI—you are making active management decisions. Here’s why:

Most “Passive” Strategies Are Actually Active Management Strategies

When an investor chooses between two index funds with different holdings, that investor is making an active management decision just as an investor choosing between to non-index funds with different holdings makes an active management decision.

The problem starts with the creators of the index funds. Since there is not an official standard definition of what most index funds should hold, ETF and fund houses are free to create as many different varieties as they wish –and, boy, do they take advantage of this little loophole.

The 89 “index” ETFs I cover track 88 different indexes. My research reveals that two funds with nearly identical labels might track completely different indexes, giving them drastically different holdings and weightings.

In other words, given the number of choices for index funds in almost every segment of the market, it is practically impossible to make a “passive” choice.

Case in point: By their titles, one would expect Mutual of America Institutional Funds, Inc.: Mid-Cap Equity Index Fund MAMQX and Fidelity Salem Street Trust: Spartan Mid Cap Index Fund FSMDX to track the same index. Such an assumption would be mistaken. MAMQX tracks the S&P MidCap 400 Index, while FSMDX tracks the Russell Midcap Index.

If you think these two indexes are practically the same, think again. FSMDX has nearly 800 different holdings, while MAMQX has only 400. The top five holdings of the two funds share no stocks in common. MAMQX earns my Dangerous rating due to its 41% allocation to Dangerous-or-worse rated stocks, which includes three of its top five holdings. FSMDX, on the other hand, allocates to less Dangerous stocks and earns my Neutral rating.

Whether you know it or not, choosing one index versus another is an active management decision that can have major implications on the performance of your investment portfolio.

And it is not just performance that investors need to worry about. Sometimes, the exposure you expect to achieve is not what you think you are getting.

Index Funds Do Not Hold What You Think They Hold

My examination of index ETFs turned up some surprising holdings that don’t mesh with the stated purpose of their indexes. Here are a few of the most glaring examples:

1)     ALPS/GS Risk-Adjusted Return U.S. Large Cap Index ETF GSRA: a top five holdings is Nu Skin Enterprises, Inc NUS, with a market cap of only $3.4 billion. Large-cap is a broad definition, but it’s hard to make the case that it goes as low as $3.4 billion.

2)     iShares Russell 2000 Value Index Fund IWN: Its top holding is Ocwen Financial Corp OCN, which has a price to book of 3.4 and a forecasted earnings growth rate of 205% for 2013. Treating OCN a value stock is a stretch as the Russell 2000 Value Index has an average price to book of 1.4 and a long term forecasted growth rate of just over 10%, and the fact sheet claims the index only includes companies “with lower price-to-book ratios and lower forecasted growth values.”

3)     iShares Russell Microcap Index Fund IWC: All of the top five holdings—RDN, AEGR, ARCP, CLNY, and VRTS—have market caps above $1.5 billion, hardly microcaps. What’s worse, the fact sheet for the ETF specifies that it should contain companies ranging in market cap from $50 to $550 million.

Without due diligence on holdings, investors do not see that these funds put money in stocks that don’t fit the criteria implied by their labels or fact sheets.

Even If Holdings Are the Same, Weightings Can Be Totally Different

Even when two funds hold the same stocks, the weighting of those holdings can be meaningfully different.

iShares Dow Jones U.S Technology Index Fund IYW and iShares Goldman Sachs Technology Index Fund IGM have the same five stocks in their top five holdings, and both weight their holdings by market cap. However, IGM caps their allocation to any individual stock at 8.5% of total assets. Due to this cap, IGM allocates only 8.5% to Apple AAPL, compared to IYW’s 16.5% allocation. If you don’t think that difference matters, just compare IGM’s return this year (+13.5%), to IYW’s (+8.7%).

Even the difference between an index ETF that weights the S&P 500 by market cap SPY and one that equal weights the S&P 500 RSP can have a significant impact. Over the past year, RSP is up over 32% while SPY is up 26%.

Those investors who bought SPY over RSP bet on the largest companies like Apple and Exxon Mobil XOM outperforming the smaller companies in the S&P 500, which did not happen over the past year.

The weighting methodologies of indexes can be very opaque and confusing at times. For instance, the iShares Dow Jones U.S. Broker-Dealers Index IAI somehow has the $1.4 billion market cap Knight Capital Group KCG as its top holding over Goldman Sachs GS and Morgan Stanley MS.

Without doing their due diligence on the holdings, investors in IAI would not realize that 7.4% of their money goes into KCG.

The Takeaway: You Need To Analyze Fund Holdings

Without due diligence on fund holdings, investors cannot know that they are buying.

Just being in a fund does not, unfortunately, satisfy fiduciary responsibilities or ensure an intelligent decision.

Fund labels don’t tell the whole story. Make sure that you or your advisor is doing their diligence when picking ETFs or mutual funds.

There is no substitute for good due diligence.

On the other hand, there is plenty of potential for ugly surprises for those who do not do their diligence.

Sam McBride contributed to this report

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.