Severe Limitations of An Index Fund
Alright, I’ll veer a little from my usual credit card rant. But this is something I have to get off my chest.
The Wall Street earlier this week finally published an a fact that I’ve known since the end of January this year – which is the S&P index has essentially been flat this decade. YES, you’ve heard it right, it has been flat this decade.
Which brings us to an interesting question? Are index funds as great as they are made out to be? Index funds obviously have their advantages. They are low cost and tax efficient. However, the main disadvantage is that they follow the market and an investor in an index fund essentially assumes market risk.
There have been many raving fans of index funds in the pf blog world. For example, Free Money Finance wrote a few posts on why he likes index funds. Advanced Personal Finance also recently posted his IRA asset allocation on the blog. Moolanomy has also written about the virtues of having index funds as a sensible strategy. The Simple Dollar (an influential voice in the personal finance space) is also a huge fan of index funds
Supporters of index funds will insist that most (or rather the average mutual funds fails to beat the S&P index over the long run). While that may be an important statistics, they disregard the fact that most funds should never be compared to the S&P index. A large cap value fund for example, should be compared to the large cap value index (perhaps a Russell 1000 value index). But the biggest problem with index investing is that is the market is negative or flat, you perform as in line with the market. For a young person or couple, one might argue that one can ride it out in the “long term”.
However, you may not have a “long term” horizon! How is that so? Well, imagine that you were 55 years old in 2000 and you plan to retire when you are about 62 or 63 years old (2008?). Back in 2000, you did some financial planning and you decided on an asset allocation model and implicit in that model is the fact that you would expect stocks to achieve an ‘average return’ of about say 8%. Your financial planner decides to get you invested in a Vanguard S&P index fund because of its low cost. Well, the results weren’t too pretty.
Or imagine that you retired in 2000! I’m sure many folks did. Once again, let’s assume that you sat down with a financial planner and figured out an asset allocation model which should enable you to achieve your desired standard of living. But I bet that for most folks who retired in 2000, they would have to adjust their lifestyles. The S&P declined about 40% from peak to trough in the early 2000s. Now try telling these retirees that index funds are great!
The fact of the matter is this : Absolute Returns DO Matter – not relative returns. It’s no use saying that your portfolio declined 30% in the early 2000s and be happy because it outperformed the S&P!.
The other problem with indexing in general is that most indexes are weighted by market capitalization. This presents a problem because as the market rallies, you end up ing more expensive stocks! So as you were dollar cost averaging into a typical S&P index fund in early 2007, you were ing over 35% of financials (which was the weightings then – it is now lower). Or consider that in the late 80s if you bought an EAFE index (for international investing), 80% of the then EAFE composition was in Japanese stocks. And they now comprise only a fraction of that. Hence, you would have ended by ing Japan at inflated prices! But hey indexes are the way to go and they are low cost!
But can you on hindsight pick funds that will put you ahead? Well, there are funds that would have given you positive returns this decade (talking about large cap funds – since the S&P is a large cap index). And anyone could have picked these funds in 2000s. The thing they had in common even in 2000 was a 10 year track record. Here are some gems :
For those of you value believers
Eaton vance Dividend Builder A
Dodge and Cox Stock – a favourite.
American Century Equity Income
General Large Cap Stocks
American Funds Fundamental Investments – Hey – it’s American Funds.
Davis New York Venture – which is actually a value fund that has been categorized as large blend by Morningstar.
The reason I wrote this post is that I think too much credit has been given to index funds and not too many posts have been written on risk versus returns. With an index fund, you are essentially accepting market risk. But the biggest danger to long term wealth is actually the volatility of your portfolio. Obviously, you could lower the volatility of your portfolio with proper asset allocation. But most posts written on the web and even in mainstream publications always encourage a large portion of your investments to be in stocks because “in the long run”, they outperform most other asset class. Well, from the peak of the stock market in 1929, it was not until 1054 that the market was essentially at the same levels (yes more than 2 decades). From the peak of the early 70s, it wasn’t until 1985 that the indexes caught up with those levels. And now, it’s been flat for 9 years since the beginning of the new century. Like I said, if you are in your early twenties, time is on your side. But the those in their 50s or nearing retirement age, you have to think long and hard about their investment strategy.
And I suggest that one takes a long hard look at the assumption that index funds are the end all and be all. They obviously have a place in your portfolio and I’m not saying it’s bad. But too little has been written about their downsides.
