How to Predict the Future, with Motorcycles and Department Stores

It is rare that we can accurately predict the future, but here is one case where we can confidently do so. On Monday June 22nd, millions of people will sell all of their shares of Harley-Davidson (manufacturer of motorcycles) and Nordstrom (department store with legendary customer service). In addition, millions of people will use the proceeds from these sales to purchase three stocks and we know precisely which ones they will buy.

How do we know this, and how can understanding this be an advantage for a successful long-term investor?

First, the numbers: as you may know, the S&P500 is an index consisting of the 500 largest companies in the United States. It is by far the most popular index published by S&P Dow Jones Indices, it is reported daily in the news, and is what most people refer to as "the S&P".

Many people are unaware of the S&P MidCap 400 Index and S&P SmallCap 600 Index, which are distinct from the more popular S&P500. The SmallCap 600 contains companies between $600 million and $2.4 billion in market capitalization (which is share price times number of shares outstanding, both of which are public information). Companies between $2.4 billion and $8.2 billion can be components of the MidCap 400. If a company has a market cap in excess of $8.2 billion, it can become eligible for inclusion in the S&P 500.

Index funds are the dominant investment vehicle for investors, holding over half of all American invested money.1 As of June 16, 20202, of the top ten mutual funds or ETFs in the world, four are money market funds and six are index funds. Of the six that are composed of stock indexes, four are tied to the S&P 500, totaling over $984 billion dollars in assets.

The market capitalization of publicly-traded companies changes daily with fluctuations in their share price, which of course is visible to the public. In order to make sure that the different indices are accurately representing their target market segments, S&P Dow Jones Indices rebalances the list of members in each index quarterly in March, June, September and December. There are predetermined rules for determining inclusion (or exclusion) from each index, and one can easily determine which companies are moving in or out of a given index well ahead of the official quarterly reconstitution.

Because of declining market capitalizations, Harley-Davidson Inc. and Nordstrom Inc. (as well as Alliance Data Systems) will fall out of eligibility for inclusion in the S&P 500 and will be replaced by Tyler Technologies Inc., Bio- Rad Laboratories Inc., and Teledyne Technologies Inc. at the next index reconstitution. Harley-Davidson, Nordstrom, and Alliance Data Systems will move to the MidCap 400 Index.

Therefore, we know that:

  1. Millions of people own S&P 500 Index funds,
  2. All of these people will be selling Harley-Davidson, Nordstrom, and Alliance Data Systems
  3. What they are adding to replace these holdings,
  4. Exactly when they will be doing this: June 22, 2020.

A knowledgeable investor is aware of these things ahead of many of the people who own the index funds. It is not hard to imagine the kind of long-term disadvantage an investor experiences by being repeatedly but unknowingly exposed to this impact, which we can call the "index reconstitution effect." Every time that indexes reconstitute is an opportunity to arbitrage against index investors, which becomes a measurable drag on their returns over time. Researchers have calculated that investors in funds linked to the Russell 2000 and S&P500 lose between $1.0 billion and $2.1 billion every year as a result of the effect for the two indices combined!

The only difference between reconstitution becoming an advantage or a disadvantage to an investor is this knowledge.

What We Think

There are three variables in any transaction: what to buy, when to buy, and the price. Unfortunately, a buyer can only control two of the three. For example, if you need to buy a specific model of car and you need to buy it today, you surrender control of the price to the dealership. On the other hand, if you can be flexible with which car and/or you can afford to wait, your ability to demand a certain price increases significantly. When it comes to investing, the price is the most important variable to have control over.

"The more you know, the more you see." -Aldous Huxley

We think that index investing gets a lot of things right: very low cost, easy broad diversification, and avoidance of emotion-based market timing. The index reconstitution effect is well-understood in academia, but is not widely understood among investors. Although index funds can be appealing due to very low fees, it is important that long-term investors consider hidden costs. By demanding specific securities on a specific day, through a method that is visible to the rest of the market, index funds lose control over pricing.

We believe that Acadium's factor-based approach to investing captures the beneficial elements of indexing noted above, but allows crucial time flexibility in trading. Because we use funds that are not forced to track indexes in lockstep, we can focus on the thing that matters most: the price. This allows us to help mitigate the effect of index reconstitution discussed above and potentially add value over time.

Frank Hujsa, CFP®, CLU®

Partner, Acadium Financial Partners
27499 Riverview Center Blvd, Suite 108
Bonita Springs, FL 34134

Any opinions are those of Frank Hujsa are not necessarily those of Raymond James. Securities offered through Raymond James Financial Services, Inc. member FINRA/SIPC. Acadium Financial Partners is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc.

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results.

This is not a recommendation to purchase or sell the stocks of the companies mentioned. Every investor's situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment. Prior to making an investment decision, please consult with your financial adviser about your individual situation.