During the last 15 years more than $800 billion dollars has been contributed to index funds. At Selective we believe there are many limitations to these products and don't truly capture the heart of investing - business ownership. To learn more go through the presentation. If you would like more content like this visit us at www.selectivewm.com or contact us at info@selectivewm.com

1. Selective –
The Pitfalls of Indexing
Selective Wealth Management
02/11/2016
www.selectivewm.com
info@selectivewm.com
434.515.1517

2. Disclaimer
 Please read the disclaimers at the end of this slide presentation. Thank you.
 To view more educational content by Selective visit us at
https://www.selectivewealthmanagement.com/resources

3. The Trend
 Since 2000 investors have been flocking to index funds in droves.
 During the last 15 years more than $800 billion dollars has been contributed to
these investment products.
 The total amount of assets dedicated to index investing is more than $2 trillion
dollars.
 Approximately 82% of theses products are designed to track indices such as the S&P
500 or other domestic and international stock indexes.
 How much do most investors and financial advisors actually know about these
products?

4. What is an Index Fund?
 An index is a collection of companies that is used to monitor the performance
of a specific sector of the global economy.
 A theoretical exercise that involves grouping businesses.
 The most widely known index is the Dow Jones Industrial Average.
 At it’s inception it was designed to provide an overall measure of the health of the
US industrial sector.
 Other currently popular indexes include the S&P 500, Nasdaq Composite,
NYSE Composite and the Russell 2000 – just to name a few.
 An index fund simply purchases all the businesses listed in a specific index.

5. What is an Index Fund? - Continued
 An index fund creates a low cost way to own a broad range of companies
across a wide variety of industries.
 Fees are low because there is no human involvement in decision making
process.
 While the low cost structure is enticing there are meaningful drawbacks:
 Poor selective criteria for investments
 No consideration for price
 Full participation in market bubbles
 Missed buy opportunities
 Indiscriminate selling

6. Poor Selection Criteria for Investments
 Once an index fund is created, rules are established to execute trades in the
market.
 Typically, the rules are designed to maximize the potential size of the index fund, which
in-turn maximizes the potential profits for the fund creator.
 To discuss this point we’ll discuss the rules used by the most widely utilized index
– the S&P 500.
 When the paper definition of the S&P 500 index becomes a vehicle for investment in real
markets complications arise that make it difficult to perfectly mirror the index. The
index fund creator must first decide how much of each of the 500 companies should be
purchased. An equally weighted index would place 0.2% (1/500th) of your investment
into each company, but this creates problems for the index operators. The smallest
companies in the index are much more difficult to purchase at equal weights because
there is considerably less liquidity in smaller issues. To avoid this problem S&P 500 index
funds are market capitalization weighted – meaning bigger businesses receive a higher
level of investment. The largest 50 companies in an S&P 500 index fund represent nearly
half (44%) of your investment. We believe this is not the optimal way to invest; it does
not make sense to allocate more investment resources based on size alone – bigger is not
always better.

7. Poor Criteria - Continued
 Another factor that impacts liquidity in capital markets is insider ownership.
 Companies with large ownership percentages held by founders or owner/operators have less
common shares available for index funds to purchase. The shares available in the open market
is known as ‘float’. Without sufficient float an index fund will not be able to purchase the
shares required to mirror the index. For many decades Berkshire Hathaway was 40% owned by
Warren Buffett, meaning only 60% of the company was available for other shareholders. In a
tightly held corporation, such as Berkshire, it is more difficult for index funds to buy shares
based on market capitalization because not all of the shares are for sale. To address this issue
S&P 500 index funds are ‘float-adjusted’. The float adjustment subtracts shares that are held
by insiders when considering the market capitalization of the business. This allows the funds to
purchase less of businesses that are tightly held. While this system makes sense for maximizing
the size of the index fund it makes very little sense as a rational for investment. Often times
the very best investment opportunities have high insider ownership. Founders tend to be
highly motivated, visionaries, owner-oriented, and very shareholder friendly (after all, they are
the largest shareholders). Many of the best companies of the last 100 years had exceptionally
high percentages of insider ownership – including Microsoft, Oracle, Google, and Berkshire to
name a few. Blindly purchasing businesses based on size and avoiding companies with high
insider ownership is a poor selection criteria for investment. Our Selective Process specifically
seeks out companies run by world class leaders and prefers when these leaders have large
ownership stakes.

8. No Consideration of Price
 When an individual invests in an index fund their cash is immediately invested
across all businesses in the index.
 Due to the float-adjusted market capitalization weighting used by many funds,
investors tend to purchase more of businesses that have recently increased in
price.
 Indices buy more of the expensive businesses and less of cheap businesses – ignoring the
old adage to “buy low, sell high”.
 We know that great investment opportunities are not available every day and that
the best opportunities are worth waiting for.
 Portfolio construction takes time and by patiently waiting for excellent prices it
can improve investment results.
 We strongly believe that price is one of the most important elements to
investment success.

9. Full Participation in Bubbles
 Free markets periodically produce episodes of extreme exuberance that create
market bubbles.
 In 2001 Cisco Systems was trading at more than 200x earnings.
 Over the next decade the earnings of the business quadrupled, but owners of Cisco lost
over 75% of their investment value despite the companies overwhelming success due to
the excessively high price paid at the time of purchase.
 Avoiding investments when price multiples are at illogical levels is relatively easy
if a rational mind is able to assess the attractiveness of the investment.
 By ignoring the price of business index funds fully participate in market bubbles – which
can be very destructive for investors
 Today there are many businesses traded in indices across the world at price
multiples that are not justified and avoiding these situations is an important part
of protecting investment principal.
 Index funds blindly purchase all of the companies included in the index, specifically
purchasing more of higher priced companies, which is fuel on the fire of market bubbles.

10. Missed Opportunities
 During the financial crisis the most attractive investments were banks that
ranked in the top 1% in terms of asset quality, balance sheet strength, and
earning power.
 The incredibly low prices of all bank stocks made these sensational businesses a
very small percentage of the S&P 500 index and, in-turn, index owners bought
relatively less during this time of distress
 Individuals that intentionally purchased the world’s best banks during this
period made a fortune due to the fear surrounding the industry.
“GOOD OPPORTUNITIES ARE RARE. WHEN IT’S RAINING GOLD,
REACH FOR A BUCKET, NOT A THIMBLE.” –WARREN BUFFETT

11. Indiscriminate Selling
 Another disadvantage to index fund investing occurs when the constituents of an
index change
 The Dow Jones Industrial Average has seen more than 100 different businesses included
in the index since its inception (despite only being 30 companies)
 Companies are removed from indexes for a large variety of reasons and when a
business is removed – index funds are forced to sell.
 Often times this indiscriminate selling is the best place to look for great investments.
 Seth Klarman and Joel Greenblatt – two of the most successful investors of the last
50 years – both intentionally look for investment opportunities created by the
forced selling of index funds.
 There are several situations that cause forced selling by index funds: spin-offs,
mergers and acquisitions, restricting or recapitalizations, moving through market
capitalization thresholds, etc.
 Without an intelligent mind looking at each investment opportunity the
indiscriminate selling can be costly for index fund investors.

12. Disclaimers
 This communication shall not constitute an offer or an invitation to trade or
invest. No party should treat any of the contents herein as advice. This
document expresses the views of the author at the time of publication and
such views are subject to change without notice. Selective Wealth
Management (“Selective”) has no duty or obligation to update the information
contained herein. Investing contains risk. Selective does not solicit in any
state in which such solicitation or sale would be unlawful prior to registration
or qualification under the laws of any such state. Investing contains risks. Past
performance is not necessarily indicative of future results.
To learn more:
- www.selectivewm.com
- info@selectivewm.com
- 434.515.1517