The Danger In Index Funds

by: Nicholas P. Cheer

Summary

Investors are leaving active managers in droves and buying index funds assuming they are well diversified and offer low cost; they do neither.

An index fund is constructed with the firms with the highest market cap getting the most weight. This makes them highly speculative and riding the wave of momentum.

Index funds are far more expensive in total cost than disciplined value investment portfolios.

"The sad reality is that index funds have turned ordinary investors into the pawns in a game that undermines the integrity of American markets and imposes costs on society that don't show up in index fund expense ratios. We believe that one consequence of this is that billions of dollars of value created by American companies are being diverted to a select few executives, while ordinary investors, distracted by "low fee" hype, are subjected to dangerous risk concentrations in their retirement portfolios." -Wintergreen Advisors

Beware of Index Fund Marketing

I get the argument all the time...everyone should ditch those active, high priced managers, and just index your money for a fraction of the cost. It seems simple enough.

But I think those who are falling for this argument do not seem to understand that the large index providers are in business to make money. They are not a charity, even though they market themselves as the savior of the individual investor. As a business, their argument for why one should index is nothing more than marketing, and in the process investors exhibiting a bad case of recency bias are falling for it, switching over to index products in droves and in the process increasing their risk.

As index funds become more and more of the market of investment dollars, these index providers are owning a larger and larger piece of corporate America, which has serious implications for capitalism, and the analysis of value. Efficient market proponents do not see undervaluation as a possibility, they believe that all stock prices are always correct, therefore investors should just mindlessly buy, buy, buy those index funds. I disagree, this is the worst thing investors can do, especially at this point in the cycle. The following is a chart from Wintergreen Advisors showing the combined ownership of America's largest publicly traded companies by index providers.

Indexing is Not Investing, It is Speculating

"The exodus of investors from flexible investment disciplines to passive investing and indexing, at valuations that are among the most obscene in history, is a symptom of a performance-chasing mentality dressed in the clothing of prudence."

-Dr. John Hussman

How is indexing speculating you ask? Well, those who purchase index funds are doing so to buy the whole market, therefore there is no fundamental analysis of whether the market constitutes a good investment, because according to the efficient market hypothesis or EMH, prices are always correct, and thus investors should always buy the market. Therefore, you are not making an investment per se as much as you are speculating on the future value of the market as a whole.

This is completely different from value investing which seeks to make investments in real businesses at prices that are below their intrinsic value. Because EMH does not believe in the concept of undervaluation, because prices are always correct, it is thus advocating not so much investing as speculating.

The negative effects of the influx of assets to index funds are well documented. From distortions in asset prices, to higher costs than investors realize, to higher risks than many active funds, index funds are a poor choice for your hard earned money. Additionally, the risks posed by index funds in rubber stamping nearly every proposal of management creates an additional risk for investors and for capitalism itself.

The move to index funds is staggering. People are moving in droves to index products convinced that those "expensive" active funds are poor investment vehicles. Who needs to consider what something is worth - I mean markets are efficient after all, or so they argue. But when we dig deeper into the data we see that index funds are offering investors anything but what they think they are getting. Most investors make the switch to index funds because they believe they are cheaper; they are not. They believe they are well diversified; they are not. They believe they are less risky; they are not.

Those who put their money in index funds are riding a wave of speculation, putting their long-term goals on the hopes that already inflated assets can continue to rise in perpetuity consistent with Efficient Market Hypothesis (EMH) dogma that got so many people in trouble in 2000. Those of us who have seen and studied many market cycles know that what goes up must come down. We have seen this type of mania before and it does not end well for the individual investor. The current valuations of the market are obscene, and while I don't expect them to decline any time soon, I do believe that now more so than usual is the time for active management, not index funds. Yet the exact opposite is happening as more and more investors are ditching active managers convinced that index funds are a better investment vehicle. They are not.

Investing is a process that is driven by research, where the prospects, and fundamentals of a given security are analyzed and there exists a gap between what a company is worth versus what the company is currently trading for. Disciplined value investors can take advantage of these mis-pricings, and outpace market indexes over the long run. Instead of following this time-tested approach, which has worked for over 80+ years, investors are falling for the appeal of index marketing, which is taking advantage of nearly nine years of QE fueled, low volatility markets that has seen short term outperformance for market indexes.

Yet investors fail to understand that the notion of index funds as an investment strategy is relatively new. The first index fund available to the retail investor was the Vanguard S&P 500 Index (MUTF:VFINX) which came on the scene in 1976. Therefore the data for index funds in the real world is limited. Those who advocate for and put together the marketing for index funds have largely been even more successful recently because of extraordinary monetary policy which has created a market that has advanced straight up with virtually no volatility. This has created an unstable environment for investors.

"If you would be a real seeker after truth,
it is necessary that at least once in your life you doubt, as far as possible, all things."
- René Descartes

The following are three of the many reasons why you should reconsider your decision to leave value investing behind to buy index funds.

1. Index Funds are Expensive

This is true in more ways than one. First off, the Vanguard Total Stock Index (MUTF:VTSMX) currently trades at 26.9x earnings. A deeper look at market valuation shows that this is the second most overvalued period behind the 2000 tech bubble. This is not a prognostication on where stocks go from here - I have no crystal ball - but it is an indication of where we are in terms of valuation from a historical context. Now is especially not the time to be buying index funds.

Second, most investors are focused only on the expense ratio of a given investment. Index proponents would argue that there is no comparison between an index product which charges a mere 0.05%, vs. an actively managed fund that charges 1% or more in expenses. In reality however there is no disclosure for the real cost of an index investment. You have to search through filings and calculate it yourself. Wintergreen Advisors has done just that, in a rather thorough analysis, and found the expenses to be upwards of 4.2% for the S&P 500 in indirect cost.

2. Index Funds are not as diversified as you think

While many investors think they are well diversified owning the whole market, in reality the majority of the return comes from just a handful of stocks. Because the stocks at the top continue to get more and more money as more investors buy into index funds it continues to drive these stocks higher without regard to value. This creates more instability in the market, and ultimately increases the concentration risk within the index fund which relies on relatively few stocks to provide the lion's share of returns. This kind of drastic overvaluation creates large risks resulting in a larger fall during the next financial crisis.

For example, 50% of the year to date gains in the index are from just 5 stocks. Additionally, it should be noted that as more and more speculators turn to index funds, it continues to push the prices of those securities up without regard to their fundamentals. So what you have in an index fund is not an investment per se, but a speculative machine, being driven higher and higher as a result of massive inflows and continued price momentum.

"I don't believe that what passive investors are doing here actually represents 'investment' in any valid sense of the word (i.e. purchasing a stream of future expected cash flows at a price that implies a satisfactory risk-adjusted return), but it does address the psychological desire to experience the same fluctuations that others do."

-Dr. John Hussman

3. Index Funds are Risky

Not only are index funds non-diversified, providing investors higher exposure to risk factors, they are also causing investors to misunderstand their risk level. As investors build a portfolio their indexes tend to be positively correlated to each other so, an investor's volatility, and overall possible exposure to left tail events is greater with an indexed portfolio. The index fund is maximum risk for below average return - not a very compelling investment thesis.

For example:

I routinely see investors choosing to index. They create a portfolio that looks something like this: a US market index, an international market index, and a corporate bond index. Many investors believe that this constitutes a well diversified portfolio because they own thousands of securities in this portfolio, being persuaded by market indexers that they have no need for a financial advisor, or any financial professional, and that by indexing they can do it alone. But in reality the risk of each one of these investments is highly correlated to each other so that when a 2008 left tail event occurs, they are subjected to serious losses. Let's look at a 2008 example:

Total Portfolio Performance 2008 -30.10%
Real Loss on $1,000,000 Portfolio $(300,990.00)
Subsequent Portfolio Value $699,010.00
Risk Free Rate as of 01/2008 (10 Year Treasury) 3.91%
Break Even at Risk Free Rate After 1 Year $1,039,100.00
Gain Needed to get back to RFR Break Even $ $340,090.00
Gain Needed to get back to RFR Break Even % 49%
2008 Market Performance Data Allocation Performance
Vanguard Total Stock Index 40% -36.48%
Vanguard Total International Stock Index (MUTF:VGTSX) 30% -45.53%
Vanguard Intermediate Term Investment Grade (MUTF:VFICX) 30% -6.16%

We can extrapolate many points of learning from the data. First, while bonds are less correlated with the equity markets, you can see they are still positively correlated to equities, as every investment suffered a loss in the period, meaning that this portfolio is not at all diversified the way the investor thought. Risk factors were highly correlated. This increases the risk for the investor of the permanent impairment of capital due to behavioral anomalies, such as selling at the wrong time, failing to invest at the right time, etc.

Second, this one event wiped out more than 30% of an investor's portfolio. For a retired investor, depending on the income or gains from the portfolio to fund their lifestyle, a tail risk event like 2008 is catastrophic, taking close to 50% gain just to get back to even with the risk free rate.

Active Investing Is Superior to Indexing

Investors are taking a great deal of risk in their index fund portfolio and they do not even know it. Most investors have been persuaded by two fundamental factors 1. The fee is lower, or so they think, and 2. Putting their money in the hands of an index provider, gets it away from those "dangerous" "high priced managers."

Investors fail to understand that true active management is a misnomer, and true active managers are not very active at all. Value investing is more about patience than activity. In reality, a better way to invest is to know what you own and why you own it. Go through the process of selecting individual securities that are purchased with a margin of safety, and hold completely uncorrelated assets to reduce risk in the portfolio.

Investors throwing caution to the wind and mindlessly buying index funds will grow to regret that decision in the years to come. It is very easy to own an index when it goes up, unchallenged by the winds of volatility. It is quite another when volatility returns to the market, or a left tail risk event hits seemingly out of nowhere. Investors are playing a game of musical chairs, attempting to ride the wave of market momentum as long as possible. When the music stops those who abandoned value investing for the simplicity of index funds will be scrambling to find a chair.

In conclusion investors are taking a great deal of risk with index funds. I'll leave you with a great summary from Wintergreen Advisors of the problem with index funds and the risks investors are taking by making the switch to index their hard earned money. Disciplined value investing is generally always the better choice. Invest with a value philosophy and stay the course.

"As indexation takes on mania-like proportions, markets become dominated by the movement of a narrow group of mega-cap stocks. Thousands of companies are overlooked and left by the wayside; they are deemed to be less desirable for no reason other than the fact that they are not included in the index. Business valuations and fundamentals have seemingly ceased to matter, with stock prices largely determined by momentum. Somewhere, Ben Graham, the father of value investing, is rolling over in his grave.

This momentum-driven style of passive investing has worked wonderfully over the past six years, as the U.S. market has been on a nearly relentless upward trajectory. The flood of cash into passive investments without regard for any sort of underlying fundamental analysis of valuation leads to a continued emphasis on companies or sectors that are popular - since they are performing well, as long as the flows into passive funds continue, they must continue to go up.

But what will happen to investors when the music stops and the punch bowl is taken away? We believe that the same small group of companies that have led the market's rise will likely be among the biggest losers, as passive funds are forced to sell the largest and most liquid names in the index.

Being 100% invested and holding zero cash, such as index funds are, has been a great boon to their performance on the way up, but we think will only cause pain on the way down. As many of these passive vehicles are being marketed to ordinary investors as diversified and less risky, they are going to be in for a shock when the momentum trade reverses.

When the market turns, investors who were seduced by the illusion of safety and "low fee" hype will discover that they took on far more risk than they realized. At that moment in time the momentum will take a reverse direction and losses incurred will be many multiples times the perceived "savings" on fees. Those looking at retirement in a few years will have little time to recover and considerable pain to bear."

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.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.

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