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### A tutorial on the dangers of Indexing investing.

Know what you are doing IF you buy index funds! You can learn a lot by studying **Horizon Kinetics. ***The video provides a valuation of the index and how to think about investing or not in indexes.*

### It’'s One Thing to Not Know, It's Another to Be Told What Isn't So

**Unpacking a Mainstream Index, the NASDAQ 100**

First, the Label

The essential value of an index is that it is a passive form of investing, the opposite of active management. The active manager’s results are dependent upon security selection; in contrast, indexation’s foundational intent is that the results will derive from broad exposure to a vast array of securities; that no individual security will dramatically impact the result – the entire idea is to avoid company?specific risk.

This might seem self?evident. But, of course, we write this for a reason. Those who subscribe to and practice indexation—which is increasingly becoming everyone—might wish to take an actual look at the NASDAQ 100. This is a mainstream index, intended to be the 100 largest firms of the NASDAQ Composite Index, which now contains over 3,000 firms. It is available via the popular PowerShares NASDAQ 100 ETF (ticker QQQ), which has almost $50 billion of assets, making it one of the country’s 10 largest.

Just the top five holdings in the NASDAQ 100, which are Apple, Google, Microsoft, Amazon and Facebook, total 41% of the value of the entire index. If an active manager presented that level of exposure, it would be daring, to say the least. In some jurisdictions, it would violate regulations.

For example, in the European Community, what are known as UCITS1 funds cannot have more than 40% exposure from position sizes of 5% or greater. To do so is considered reckless. Yet, the NASDAQ 100 is available via the iShares NASDAQ 100 UCITS ETF (CNDX LN). It has over $1.1 billion in assets under management in the UK alone. In other words, concentration risk that is forbidden to an active manager is considered reasonable and permissible if it happens to be an index. Clearly, this index is the opposite of diversified – its results depend powerfully on individual securities.

Second, Valuation: When is A P/E Not a P/E ?, or How To Turn 90 into 22 in Three Easy Steps

According to the PowerShares QQQ fact sheet, the P/E ratio of the NASDAQ 100 is 22.19x, calculated on a trailing basis, and that is roughly comparable to the P/E of the S&P 500. No doubt, the P/E – the price, in essence – is an important fact for investors who are considering whether to own it or not. But is it really a fact, as we think of facts? Because the QQQ P/E is not the simple mathematical average of the P/E ratios of all of the companies in the index, as one might naturally expect.

First, it is calculated by excluding all firms with negative earnings. It also effectively excludes companies with excessively high P/E ratios. Would you do that? Does it make sense?

Let’s reason through the easy one first, the idea of excluding companies with negative earnings. For the simplicity of round numbers, say an investor in private businesses made a $1 million investment in each of 3 small companies, flower shops, convenience stores, what have you, for a total of $3 million. One business earns $100,000 per year, so it has a price?to?earnings ratio of 10x; the second earns $50,000, for a P/E ratio of 20, and the third earns only $20,000 and so has a P/E of 50. This last one is probably situated on a highgrowth street corner. Averaging the three P/E ratios of 10, 20 and 50 means that the average P/E of the 3?company portfolio is 26.7x. So far, so good.

But what if business number two loses $50,000 a year instead of making $50,000? One can see that averaging the three P/E ratios would be misrepresentative, because then the average P/E ratio would be 13.3x (+10, ?20 and +50, divided by 3), which is one?half as expensive as the original P/E of 26.7x. Obviously, the portfolio with a loss?generating company is not cheaper than the all?profitable one. In a sense, the ETF organizers are staying within the logic of averaging individual P/E ratios by eliminating the company with the negative P/E ratio from the calculation as a statistical aberration or outlier. As if it does not exist or have an impact. The resultant P/E, however, does not represent reality.

To try representing reality better, how do we imagine the private investor would look at his or her investments? I think we all know they’d at actual dollars. Perhaps they would add up all the earnings of the three businesses, which in the first instance was $170,000 ($100,000 + $50,000 + $20,000), and compare that with the $3 million of total investment: that’s 17.1x earnings. In the second instance, including the business that loses $50,000, the three together earn $70,000 a year, not $170,000. Earnings of $70,000 is not a lot for $3,000,000 of investment; that’s 42.9x earnings or, in income yield terms, 2.03%. That’s reality.

So, in reality one knows that an unprofitable company makes an investment more expensive, while in the world of indexation, such as in the QQQ, unprofitable companies are eliminated, making the P/E lower.

Now for the more interesting technique of P/E reduction: neutralizing the impact of the excessively high P/E ratio. Companies with very high P/E ratios, say over 100, are effectively eliminated from the calculation of the QQQ valuation. For instance, in 2016, Amazon earned $4.90 per share. The trailing P/E for its current share price would be roughly 188.7x. Since Amazon is a 6.82% position in the NASDAQ 100 Index, its full inclusion would raise the index P/E by some appreciable and observable degree.

Similarly, by this convention, which we’ll explain shortly, there is no way of informing prospective NASDAQ 100 purchasers of the valuation impact of holdings other than Amazon, such as Netflix, Tesla, and JD.com.

Their trailing P/E ratios are 191x, ?82x (yes, that’s negative), and ?117x, respectively. Such names effectively do not exist from a P/E risk measurement perspective, even though as weightings in the index they definitely affect the risk of any dollar invested in the index.

**Read the full article here: http://horizonkinetics.com/**

Also, more on indexing here:

Q2-2017-Commentary_APPROVED_FINAL

**Article by CSInvesting**

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