Don't Buy Index Funds

Summary

• Investors are increasingly choosing to invest "passively" I will present 10 reasons why this is a mistake.
• Indexers ignore the vast amount of academic research that proves the best way to invest is through the science of investing.
• Investors are putting far too much faith in the index universe, and will once again get burned.
• Instead they should be following the science of investing, and investing with DFA.

When an investor is looking to put together an investment portfolio the popular advice these days is for them to buy a total stock market index, total international stock index and total bond market index and call it a day. In my view this is the worst thing that an investor can do. Below I will present ten reasons why I believe investors should never buy standard index funds and instead should be active investors following the science of investing.

There's no such thing as passive investing. It's true. Passive investing in its purest form doesn't exist. Only lesser degrees of active management exist. (Index funds) must be continuously maintained by real people who face difficult issues when trying to track an index. The managers must make hundreds of active decisions each day concerning when to trade, what to trade, what to do with new cash, how to raise cash when needed, whether to use futures, swaps or other derivatives, etc. There's nothing passive about managing an index fund.
- Rick Ferri, CFA

1. Index funds are NOT passive

There is nothing passive about index funds. Index funds are constantly making decisions about what to put in and out of an index fund. This makes comparisons of the S&P 500 index with other investment vehicles nearly impossible. The S&P 500 in 1976 is not the same S&P 500 of today. Passive investing is a delusion, and a simplistic way of marketing to investors that they are better off leaving their investments alone. While I would agree that behavioral mistakes of investors trying to get in and out of an investment will likely have negative consequences on their long term wealth creation. The notion that the best way to be "passive" is to buy index funds is simply untrue. There is nothing passive about index funds.

Many in the "passive" camp tend to have discussions about mutual funds in the aggregate, comparing a specific index fund to active management as a whole. This is distorted analysis that provides investors with little information that they can use to make wise investment decisions. If Instead we had specific conversations we would come away with information that is applicable to investment decision making.

For example, the recent bet between Warren Buffett and Protege Partners is getting a great deal of attention after the recent Berkshire Hathaway investor letter. Many passive investors are doing a victory lap, that this demonstrates yet again that straight index investing such as the S&P 500 or the Total Stock Index is all you need. Yet this is again distorted analysis. The comparison is between one index fund, and an array of high priced hedge funds. I find it interesting that the bet wasn't the S&P 500 beating Vanguard PRIMECAP. If it was, the Vanguard 500 Index Fund Inv (MUTF:VFINX) averaged 7.71% over the last ten years, while the Vanguard PrimeCap Core Fund (MUTF:VPCCX) averaged 9.91%, a win for active management.

PRIMECAPS Odyssey funds did just as well, even with a slightly higher expense ratio. The fund closest to the S&P 500 is the PRIMECAP Odyssey Stock Fund (MUTF:POSKX), which has returned 10.26% per year and that includes a loss of 33.27% in 2008 which certainly skews the numbers. Another win for active management.

The Mairs & Power Growth Fund (MUTF:MPGFX) is another Large Cap Blend fund since the beginning of 2008 through YTD it has returned an average of 9.5%...another win for active management.

DFA Core Equity vs Vanguard Total Stock Index over the last decade produced similar results: DFQTX 9.5% VTSMX 9.02%, another win for active management.

If you think the last ten years were an anomaly, lets check a longer term time frame.

1976-Today.

• Mairs & Power Growth total return:13,898.95%
• Vanguard S&P 500 Index total return: 6,722%

1992-Today

• Vanguard Total Stock Market Index Fund (MUTF:VTSMX) Since inception(04/27/1992): 859.06%
• Mairs & Power Growth (04/27/1992-YTD): 1,783.19%.

What about international Markets:

2001-Today

• Vanguard Total Intl Stock Idx Fund (MUTF:VGTSX): 107.95%
• Dodge & Cox International Stock Fund (MUTF:DODFX): 216.63%

What about international small cap:

2009-Today

• Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEARCA:VSS) Since inception 04/02/2009-YTD: 136.84%
• Brandes International Small Cap Equity Fund (MUTF:BISMX): 327.03%
• DFA International Small Cap Portfolio (MUTF:DFISX): 176.50%

Both forms of active management again beat the standard index alternative.

2. Index funds are GUARANTEED to underperform the index

Index funds are not interested, advocates say, in beating the market. They are willing to take the market average, and be content with the fact that they paid less. But in reality they are not getting the market return after fees. Because index funds are aiming to track an index at a fee, they are therefore guaranteed to underperform after fees.

3. Index funds have failed to vote in investors interests

Buying a share of stock represents a share of ownership within a company. Because index funds do not treat it as such, and are obsessed with holding a market portfolio, they have little incentive to vote on corporate proposals as owners. Most index funds thus vote with management whether it is in the interests of shareholders or not.

If the index fund trend continues, and it looks likely to do so, what happens when index funds control Corporate America? Courts have often deemed shareholders to be in control of a corporation with as little as 20% of the ownership of a company. At current rates of asset inflows, it will not be long before index funds effectively control Corporate America and the corporations of many foreign countries. The Japanese system of cross corporate ownership, the keiretsu, has been blamed for decades of Japanese corporate underperformance and economic malaise. Large passive ownership of Corporate America by index funds risks a similar outcome without the counterbalancing force of large active investors and improvements in the governance oversight implemented by passive index fund managers.
-Bill Ackman

4. Index funds Ignore the laws of investing

Index funds ignore the laws of investing. By buying all the securities in a given market and then weighting them by market cap, an investor owns both the good and the bad within a given market. This ignores the research of Fama/French, Novy Marx and others who have identified a significant premium for investors who weight their holdings towards the quality factor. Buying quality firms, with excellent balance sheets and wide moats provides an advantage for investors over the long run. In addition the notion that one should hold an entire market means that all the constituents are worth holding when in reality they may not be. The notion that we cannot weight a portfolio by excluding the poorly run companies and including companies that exhibit higher characteristics of quality, size, and value factors, is ignoring academic research, and creating a rather irrational approach to investing.

If an investor was going to buy a house for the purposes of earning rental income, they would assess the quality of the neighborhood and schools, the locations proximity to shopping or nightlife, and the features in the home. Each one of these characteristics would make a property more desirable to potential renters and therefore demand higher rent. Index investors buy a pool of securities in the hopes of averaging out to a market return. In reality there are ways to analyze securities, and tilt ones portfolio towards the characteristics of exceptional investment performance. Just as in the example of the real estate investor why would investors not embark on this endeavor? Index investors would say your odds of success are small and the cost is large. But is it?

DFA funds, are tilted towards the sources of outperformance identified in academic literature, the vast majority of DFA funds beat the market and do so at minimal cost. Tweedy Browne & Co. is another investment firm that has produced exceptional returns backed by academic research. Mairs & Power, PRIMECAP, Dodge & Cox, and many others have done the same. As I have stated before, we need to differentiate between speculation and true investment management. The fact that the index community attempts to analyze all active managers in the aggregate is the problem with their analysis. A fund charging 2.43% with 112% turnover has absolutely nothing in common with Dodge & Cox funds, for example, where investment managers have high investments in their funds, the funds have high active share, low turnover and low expenses. Index funds ignore the laws of investing by identifying all assets as worthy of being held in a portfolio thus ignoring valuation.

5. Index funds Do Not Make Sense

Index funds make no sense. The entire concept of buying more and more of a security as it gets more and more expensive makes absolutely no sense. Would you buy more houses as they become more expensive, or more of anything else? Likely not. There is a point at which the price versus the value would become unattractive for investment purposes. Yet index funds ignore economics by continuing to funnel capital into stocks, regardless of earnings or any other metric of company value. This is leading to a bubble in indexing that will be the subject of my next piece.

6. Index funds assume perfect efficiency

The notion of buying an index fund makes an assumption that markets are not only mostly efficient, but that they are perfectly efficient. Even professor Fama himself has admitted that they are not perfectly efficient. Furthermore, the vast amount of research that demonstrates a premium for investors that tilt towards small cap, value, quality, and investment characteristics demonstrate that there are anomalies within market structures that can be exploited to increase the portfolio return beyond merely owning a straight index fund. If markets were perfectly efficient then no active manager would be able to consistently beat the index.

7. Index funds Ignore the Allocation of Capital that is at the core of Capitalism

"If everyone does (indexing), there will be no allocation of capital to the great, high-potential projects that feed right into fixing our country's long-term problems," said Kim Shannon, founder of Toronto-based Sionna Investment Managers at a 2012 National Club debate on the topic. "The inbound capital just follows market cap, and this is counter to what investing is supposed to be about-taking on risk and getting paid for it in the long run." I agree with her sentiment. Index investing is a growing threat to our economic system, because investors and investment managers are abdicating their critical societal role of allocating capital most efficiently." Brandes On Value

Indexing relies on past winners to continue to be winners. It seems to violate the central tenet of indexing, that just because an active manager did well in the past there is no guarantee that they will continue to do well in the future. Yet index fund investors are putting their faith in the companies with the highest market cap. An investors dollar in an index fund is thus allocated most towards the most expensive companies at the top of the index, and less towards the lowest market cap assets at the bottom.

Index funds ignore the allocation of capital that is at the core of capitalism. The notion that we should all be indexing would mean the end of capitalism, the end of financial analysis, and the end to allocating capital towards cheap assets. The extreme index investors even claim that bubbles can not exist because prices are correct at all times. Yet history shows us that prices can vacillate wildly between euphoria, and despair, sending prices of equities to undeserved levels on both extremes. Research has proven that market pricing is random, and thus favors the active manager. Perfect efficiency is demanded by index investors who assume that markets will move "in order" doing what it is supposed to do according to hypotheses and assumptions. Index funds simply do not work in the real world for the long run.

8. Index funds FAIL investors at the worst times

If one was going to ascribe an advantage to active managers it is generally seen during market declines. Bear markets have an interesting way of separating the grain from the chaff. Investors always forget what it felt like to lose 30,40, or even 50% of their wealth during a market crash, and only seem to focus on the recent past. This bias, has caused investors to pile in to index funds. When the next bear market comes investors will be reacquainted with the concept of risk and return. An index fund provides investors with maximum risk and a below average return after fees. During bear markets, it is index fund investors who take on the greatest risk and thus suffer the greatest losses. Let's take the S&P 500 as an example. From 2000-2010 the index caused investors to lose 9.83% of their wealth, turning a $1,000,000 portfolio to $901,648. This was largely due to the fact that investors experienced two large drawdowns during this period of time. Yet for investors who are investing for a specific goal, losing a decade of their time to invest can have significant impact on their long term wealth creation. Plenty of evidence based, research oriented investors were able to produce significant returns during this period, proving yet again it does not pay to index.

How Long Does it Take to Get Back to Even After a Crash?
Name	Category	2008	2009	2010	2011	2012
LARGE CAP BLEND
Real $ Return	$1,000,000	$629,600.00	$810,295.20	$948,774.65	$957,882.89	$1,113,538.86
Vanguard Total Stock Index	Large Blend	-37.04%	28.70%	17.09%	0.96%	16.25%
Real $ Return	$1,000,000	$714,900.00	$875,895.48	$1,028,301.29
Mairs & Power Growth	Large Blend	-28.51%	22.52%	17.40%
Real $ Return	$1,000,000	$631,400.00	$815,453.10	$993,303.42	$972,543.38	$1,148,379.22
DFA US Core Equity II Fund (MUTF:DFQTX)	Large Blend	-36.86%	29.15%	21.81%	-2.09%	18.08%

Click to enlarge

As you can see the active advantage is well documented. Investors in MPGFX, and DFQTX made out far better than investors in VTSMX. The index fund took a full five years to return to even, and even when it did, it did not beat its DFA counterpart on performance. DFA beat the standard index fund in four out of five years. Further, MPGFX, achieved better risk return characteristics, and because it lost less during a crisis, investors in the fund were able to add gains once the hurricane was over rather than make up for extensive losses. Index funds simply expose investors to far more risk than is warranted, leaving them waiting for years to get back to even. This can make it more likely that investors bail on their long term plan. Most investors think they can hang on during a crisis, but when the winds pick up and the hurricane is upon you, most investors bail at the worst time.

9. Index funds Ignore Academic Research

Buying index funds ignores the academic research that has demonstrated a clear premium for investors who tilt their portfolio towards value, small cap, quality, and positive investment characteristics. Investors who buy index funds, such as the many iterations of the total stock index, are thus putting themselves at a disadvantage by ignoring the science of investing and seeking to place cost above the empirical research from leading financial academicians. While there is a plethora of research, some of the most important advancements that total stock index fund investors are missing out on are:

A Five Factor Asset Pricing Model

Fama & French have documented a clear advantage to value stocks over growth stocks, as well as for small cap stocks over large cap stocks. Their work also extends to demonstrating the profitability factor, as well as firms with positive investment characteristics.

Size Matters, If You Control Your Junk

Even further research by Asness, Frazzini, Israel, and Moskowitz, demonstrated the quality factor extends to the small cap universe.

From the abstract:

The size premium has been challenged along many fronts: it has a weak historical record, varies significantly over time, in particular weakening after its discovery in the early 1980s, is concentrated among microcap stocks, predominantly resides in January, is not present for measures of size that do not rely on market prices, is weak internationally, and is subsumed by proxies for illiquidity. We find, however, that these challenges are dismantled when controlling for the quality, or the inverse "junk", of a firm. A significant size premium emerges, which is stable through time, robust to the specification, more consistent across seasons and markets, not concentrated in micro-caps, robust to non-price based measures of size, and not captured by an illiquidity premium. Controlling for quality/junk also explains interactions between size and other return characteristics such as value and momentum.

Quality Investing

Robert Novy-Marx has done extensive research demonstrating the superior performance for high quality stocks over low quality stocks and seeking to exploit this factor as a separate factor subset to value. By utilizing the gross profitability metric investors can find higher quality stocks and thus create higher quality portfolios. This has a demonstrated impact on the long term performance of the portfolio.

Index investors eschew the advancements of investment science, and settle for the market portfolio, a now academically proven unwise choice.

10. Index funds will fail investors again

As so called passive investing has grown, markets have become less efficient. It is active managers that make markets work. The current rise of the index fund bubble, will undoubtedly burst, robbing investors of trillions of dollars of wealth, and reminding investors that index fund investing does not pay in the long run.

There you have it ten reasons not to invest in index funds. Instead investors would be far better served bringing the advancements of investment science into their portfolio and following an active approach of tilting their portfolio towards the sources of outperformance as DFA does. Leading academics have proven this is the best way to invest for the long run. For investors who are risk averse, less equity allocation may be the best way to ensure you will stick with your long term investment plan. Either way, investors would be doing themselves a great service by following investment science and not giving away their decision making power to index providers. DFA funds offer advanced solutions for investors, that are far superior than simply buying index funds.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.