Why Broad-Based Index Funds Are Still the Wrong Tool

by: Roger Nusbaum

In investing, there are tools at our disposal for the circumstance faced. Choose the correct tool and your chance of success increases; choose the wrong tool and your chance of success decreases. Selecting the correct tools is a top/down decision that comes with understanding the big macro picture. Key to this point is time spent and having some introspection that your general beliefs may be incorrect.

For many years the wrong tools have been broad-based index funds. I've been making this point for years, and I believe it will continue to be the case for many years to come. The logic in 2004 for this point was the U.S. as a less compelling investment destination, Europe flat out stinking and Japan nowhere close to having things figured out -- and I don't think this has changed. If these things have indeed not changed, then broad-based index funds will continue to be the wrong tool.

Interestingly, I used to get a lot more pushback on the idea that broad-based index funds are the wrong way to go -- which either means the broad-based index crowd is getting smaller, or they have collectively stopped reading my stuff.

The other day I mentioned a conference call for planning the sector ETF panel at the Inside ETF Conference next month. In our discussion, the moderator asked for our take on the extent to which most advisors use sector ETFs, although I think the implication was narrow funds, not just sector funds. I think there was a sort of consensus that most advisors do use sector funds, but I disagreed. Using broad-based funds is easy to do, doesn't require a whole lot of work, and should not do much worse than the market, which is a defensible position.

A long time ago, I was an institutional equity trader. One of my colleagues left to start her own advisory firm, planning to use actively-managed mutual funds and make the occasional change in holdings; she was convinced that this would not blow anyone up. She felt this would be a fine living.

I found out second-hand that the tech wreck crushed her client accounts. I have no idea if it put her out of business or not, but this serves as another example of a wrong tool for the circumstance. Actively-managed mutual funds with broad mandates often fall into the same problem as broad-based index funds as managers tend to follow the market: How many actively-managed funds got caught with too much tech 10 years ago?

Success, however you define it, requires adapting to the current environment -- not relying on the same thing for every environment.