In 1573 English farmer and poet Thomas Tusser gave rise to the now popular phrase “a fool and his money are soon parted” with this verse from Five Hundreth Pointes of Good Husbandrie:

A foole & his money,
be soone at debate:
which after with sorrow,
repents him to late.

What makes us foolish with our money? Well, lots of things. Too many to list.

A common foolish move is investing in something we don’t understand. That’s precisely what we do when we index with the S&P 500.

What’s not to understand? Buy a fund or ETF that invests in the 500 largest companies and get super cheap internal operating expenses. That’s a win, right?

Not so fast.

What many of us fail to realize is that the S&P 500 is a dollar-weighted index. In plain language the greater the stock price the greater the impact on the index. For example a $100 stock that increases 2% in a day will have a greater impact on the level of the S&P 500 than if a $25 stock increases 2% in a day.

Why is this important? Inertia.

Take for example modern-day darlings such as Apple, Google, Facebook, etc. The more investors want to own these stocks the higher their prices are bid up. In turn any move up or down in these stocks will magnify the gains or losses of the S&P 500.

What’s an active manager to do? Let’s say he or she has a fundamental reason for avoiding one of these stocks. It could be anything – low barriers to entry, slowing sales, inability to repatriate overseas profits, etc. The manager decides not to own the stock in the fund and when the inevitable benchmarking takes place we think, “Wow, those people are stupid. They can’t beat the S&P 500.”

We’re not arguing for or against active management or indexing. It’s simply important to understand that the process of an active manager may lead to his or her performance deviating quite a bit from an arbitrary index benchmark. And that’s OK . . . just as long as investors know why performance deviates and how that deviation (when combined with other investments of various correlation) can work in their favor to smooth out returns and minimize risk.

To read more about the phenomenon of dollar-weighted indexes and how they put active managers behind the proverbial 8-ball from the start check out this wonderful piece from Bloomberg Markets.

Caveat Emptor!