Excerpt from a February 2021 client letter:
I would like to provide two real examples of how you are invested.
The first example is how managed investments, like yours, can outperform a passive index.
On November 16, 2020 an announcement was made that Tesla would be added to the S&P 500 Index on December 18. By mandate, passive index funds typically have a narrow 10-day window to match the changes to the index.
On the announcement, Tesla’s price per share jumped 8.2% and continued to climb 70.3% in the weeks leading up to December 18. The stock climbed another 13.9% on the five days following December 18, which are final days passive index funds can add Tesla to their portfolio.
While Tesla is a large and growing company, and may even put someone on Mars one day, a wise investor would be skeptical of anything that grew that much that quickly.
In the weeks since Tesla was added to passive index funds, the price per share as fallen 4.8%.
The process of updating a passive index fund is called reconstitution, and it is one of the reasons I limit the use of passive index funds in your portfolio. The high demand of Tesla leading up the index addition date helped pushed the price up for a very narrow period. It’s an example of arbitrage and in this case, your investment portfolio took advantage of the opportunity.
Because your investments are not bound by a strict mandate to follow public indexes, you owned Tesla before the November 16 announcement. As the price of Tesla grew, your portfolio sold off shares for a nice gain.
The second example is how your investment handled the recent GameStop controversy.
GameStop has some difficult decisions to make with their ‘brick and mortar’ locations as sales continue to increase online. Speculative investors bet against GameStop leadership’s to be able to navigate this situation profitably, and placed short sells on the stock.
A group of ‘amateur’ investors, banded together, and bought GameStop driving up the price and created large losses for the speculative investors, who happen to be well connected on Wall Street.
Online trading platforms, like Robinhood stopped their customers from trading GameStop (showing where their loyalties lie?); and the price of GameStop returned to where it was before the ordeal began.
While everyone likes an underdog story, the real victim may be the person on the outside, who buys GameStop and unknowingly is left holding the bag when the party is over.
In the same way, a passive index fund that tracks the Russell 2000 index (of which GameStop is a part of) would increase the funds exposure to GameStop as the price increased; and possibly be obligated to sell those same shares once the price decreased. This is because passive index funds are not making judgement evaluations based on known information. Passive index funds are evaluated on how closely they track the index they follow, called tracking error.
Your investment had targeted a modest exposure to GameStop before the trading occurred. As the price increased, the asset was sold for a profit. Once news of the colluding investors broke, Dimensional was able to sell all positions of GameStop to avoid putting your assets into a speculative risk.
For more on this topic, Dimensional wrote an article titled, Think Investing is a Game? Stop. Let me know if you would like a copy, I can send it to you.
If you have concerns on whether your other accounts may rely heavily on passive index funds, we can review those investments to determine your best options.
I’m grateful for our partnership and for your trust as we work through the challenges of our current environment. I continue to monitor your investments and adjust your allocation to pursue your investment objectives.