The Problem With Index Funds

I was glad to see on Friday someone (Yahoo! Finance Editor-in-Chief, no less) concur with my concerns over the growth of index-based investing strategies (see “One reason I’m worried about the rise of the robo-adviser“). In a piece appropriately titled, “Pride cometh before the fall: indexing edition,” Aaron Task writes:

Was ‘owning the index’ a good idea in 2000, when ~50% of the S&P 500 was in tech?

Was ‘owning the index’ a good idea in 2008, when 40% of the S&P 500 was in financials?

No, of course it wasn’t.

But that’s exactly what you did if you followed an index-based approach. So while index investing is probably better than many of the alternatives that doesn’t mean it doesn’t have its own problems. And being valuation agnostic is probably its biggest problem.

You see when you buy an index fund you put more money into the largest companies in the index and less money into the smallest, regardless of their valuations. So when investors bid tech stocks to the moon and they become the largest component of the index (as in 2000) they carry a larger weight in the index and, in turn, you end up buying a lot of them. In effect, you become greedy when others are greedy rather than becoming fearful, as Buffett would recommend (he also recommends indexing, though, so go figure).

And taken to the extreme, the growing popularity of index-based investing could possibly be the cause of yet another stock market bubble. When a growing class of buyers is willing to continue buying regardless of how high prices rise then valuations can conceivably rise infinitely (Sound familiar? Indiscriminate buying of internet stocks in 2000? Indiscriminate buying of housing in 2007?).

What index-based strategies don’t want you to know is that ‘the price you pay DETERMINES your rate of return.’ Pay too high a price and you literally guarantee yourself horrible returns. Forget owning too much of one sector within the index; was it a good time to buy stocks at all at March of 2000 or October of 2007? Hell, no. Sky-high valuations were a big reason for that. And we may have already reached that point once again (Jesse Livermore recently wrote a wonderful piece on the topic – see “Why is the Shiller CAPE so high?“).

Finally, I personally see the growing popularity of index-based investing as a good thing for individual investors over the long-term but also as a potential contrarian indicator over the intermediate-term.

Aaron again:

The pendulum has swung way too far where everyone thinks all you have to do is index and you’re going to do better [than actively managed funds].

Once the pendulum has swung so far that many investors come to believe that all you have to do is buy the index and it’s all peaches (cap gains) and cream (dividends) then it’s probably time to look out below. I just don’t know if we’re there yet.