The Problem With Index Funds

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Includes: DODGX, OAKMX, POGRX, POSKX, TBGVX, VFINX, VPMCX
by: EB Investor

Summary

A handful of stocks are driving market averages and perpetuating a cycle of speculation that has driven stocks straight up to all time highs.

Investors are continuing to disregard price, value, and growth rates of businesses and just pile into "low cost" index funds. I believe this is a huge mistake.

I will review a far more superior approach to wealth management that applies the principles of investing that have been in place for nearly a century.

I am often amazed at the madness of crowds. Charles Mackay's groundbreaking book Extraordinary Popular Delusions and the Madness of Crowds introduced us to the principles of crowd psychology and behavioral economics. In this piece I want to continue in my exploration of why index fund investing may be hazardous to your wealth. I also want to take a brief look at the recent winner of the Nobel Prize in Economics, Richard Thaler, whose work in behavioral economics represents a clear blow to the theory that all market participants act perfectly rationally; they clearly do not.

The Index Fund Mania Continues

The rage these days seems to be dropping "active managers" and simply putting all of your hard earned money into a set of index funds which is about as logical as deciding that you don't need a doctor because medical care is too expensive, and you will do it yourself. After all why pay an expert wealth manager to manage your wealth when you can simply buy index funds and keep your wealth on autopilot for a nominal fee, right? Well, as it turns out, investors are making a serious mistake by following this course of action, even if it doesn't seem like it now. Index funds are seriously flawed, as I have laid out in several previous pieces. In addition, when we study the wealthy we will find that none of them got rich buying index funds. So it begs the question, why are people following this course of action, and possibly putting their hard earned money at risk? I think it stems from three flawed beliefs.

1. The False Idea That Index Funds Outperform Active Managers

Index fund proponents will cite the statistic that index funds will outperform 95% of active managers. So why would you want to buy an active fund when you can buy index funds and outperform 95% of your peers? This logic, however, is completely flawed. After all the fact that index funds beat the majority of active mutual funds, means nothing at all without understanding the details.

This type of analysis does not remove the closet index funds from the list, nor does it remove the trader funds, with extremely high turnover, that constitute speculation rather than investing. I would like to see a data set of true active managers with low cost, low turnover, high management ownership, and a history of positive stewardship that aligns with the academic research on what constitutes quality active management.

If we compiled this list, it would include funds like PRIMECAP Odyssey Stock (POSKX), PRIMECAP Odyssey Growth (POGRX), Dodge & Cox Stock (DODGX), Oakmark (OAKMX), Tweedy Browne Global Value (TBGVX), a number of American Funds, and on and on I could go. Each one of these funds has destroyed their benchmark fund over long term time periods, and are proof of the efficacy of a disciplined approach to investing that relies on true analysis rather than relying on the benchmark to decide what you own.

Which brings up the other flaw in the research promoting index funds, the comparisons to a benchmark and not a benchmark fund. If you are going to tell investors that they are better served by buying index funds, then why compare the results of a no fee index? Instead investors should compare the results of a large cap blend fund for example against a comparable S&P 500 Index Fund, in order to make their decision into what to invest, rather than a no fee index. As all investors know, we cannot invest directly in an index, so this data is worthless. Additionally, it is important to note that an index fund will always underperform the index after fees. So essentially investors are being told to invest using a strategy that will always underperform the index, rather than one that provides investors with the chance to outperform.

Index fund proponents will be quick to reassure you that they believe that it is possible for a small group of managers, like the list I provided above, to beat the market. They will also state that the group that wins in one period does not win in another period. Yet again, they fail to categorize these active funds. It does no good to compare apples to oranges, and that is exactly what index fund proponents do when they make statements like 95% of active funds fail to beat their benchmark. No, in reality, the majority of poorly managed, high cost, closet index funds fail to beat their low cost benchmark index fund.

Real active managers beat their benchmark the majority of the time when viewed in the context of a long term investment horizon. Let's take one of the best examples of this phenomenon Vanguard PRIMECAP (VPMCX). The Vanguard PRIMECAP fund has a nice long track record for us to examine. It has low costs of 0.39%, and turnover of just 6%, demonstrating that the firm is managing money for the long run. They even count Jack Bogle, the father of indexing as one of their first investors.

The fund began in November of 1984. At that time investors had a choice, invest $10k in the PRIMECAP Fund or the S&P 500 index fund also offered by Vanguard. Investors that chose the S&P 500 fund saw their wealth multiply from $10k to $343,833.90. for a return of 3,338.34%. Just fantastic!

But the investors that chose the PRIMECAP Fund saw their wealth sky rocket, from $10K to $763,018.66 for a return of 7,530.19%, more than double the return of the index. Many investors may think they got lucky early and simply are riding a wave. They are wrong. Looking at just the past 15, 10, 5, 3, and last 1 year periods we see that PRIMECAP beat the S&P 500, its prospectus benchmark, represented by the Vanguard S&P 500 Index Fund (VFINX) in every single one of those periods.

15 Years 10 Years 5 Years 3 Years 2017
Vanguard PRIMECAP 13.01% 10.96% 19.51% 13.70% 29.51%
Vanguard S&P 500 Index Fund 9.79% 8.37% 15.62% 11.26% 21.67%
PRIMECAP Advantage 3.22% 2.59% 3.89% 2.44% 7.84%

2. The False Idea of Simplicity

Another reason investors are choosing index funds, is the perceived simplicity they believe they are getting. "Let's just buy an S&P 500 Index for example and that takes care of everything." For this perceived simplicity, investors are paying a very high possible opportunity cost, as demonstrated in the above example with the Vanguard PRIMECAP fund. Investors are better served with a low cost, true active money manager; by selecting a group of individual stocks themselves and holding them for the long run; or through quantitative fund strategies like factor investing that seeks to harness the returns of academic research for investors. All of these approaches are superior to index funds. But for the purposes of this piece, let's focus on the concept of buying individual securities in a passive fashion, because this is what I believe is the best approach to create wealth long term.

If I took for example, the top ten holdings of the S&P 500 index and equally weighted them in an individual stock portfolio, I would have outpaced the index fund by more than double. As you can see, I merely selected the top 10 names in the S&P 500 Index Fund, (this is not a recommended portfolio, it is simply for illustration purposes). I included 10 stocks because Alphabet A & C Shares are represented here, yet they are the same company, so I only included the A Shares to ensure we get 10 different businesses to analyze. I looked at the past 11 years from 2007-2017(data through 3Q 2017).

S&P 500 Top 10 Holdings Portfolio (Data as of 3Q 2017) Cumulative Returns 2007-2017 Weighting Holding Weighted Return
Apple Inc (AAPL) 439.35% 10% 43.94%
Microsoft (MSFT) 174.42% 10% 17.44%
Facebook (FB)* 248.66% 10% 24.87%
Amazon.com (AMZN) 540.26% 10% 54.03%
Johnson & Johnson (JNJ) 117.25% 10% 11.73%
Exxon Mobil (XOM) 47.04% 10% 4.70%
JPMorgan Chase (JPM) 127.57% 10% 12.76%
Berkshire Hathaway (BRK.B) 118.87% 10% 11.89%
Alphabet A (GOOGL) 243.84% 10% 24.38%
Bank of America (BAC) 72.39% 10% 7.24%
*Data Only since 2013
Portfolio Return 2007-2017 YTD
Vanguard S&P 500 Index Fund (VFINX) 103.09%
Top 10 Portfolio 212.97%

Indexing a portfolio simply makes no sense, because it is the act of simply saying "I have no way of analyzing businesses, and so I should just own all the badly run businesses, with all the mediocre run business, and all the well run businesses all together to represent "The Market" in an index fund portfolio and I will attain an average return." But this is obviously not true, we can analyze businesses. As you can see holding the individual names provides you with the ability to outpace the index. It also provides you with the additional ability to act like an owner and vote your shares, and utilize individual holdings to benefit you from a tax perspective, taking losses against gains when appropriate.

Again, I am not advocating that investors simply take the top 10 companies and hold them, I have just used this as an easy methodology to prove my point. There needs to be a way to screen for the most profitable firms, and those that are of high quality that will allow your capital to grow at higher rates over the long run. Investing in publicly run companies needs to be treated with the same philosophy and approach as investing in private businesses. Investors should stop ceding their control over to the S&P 500 investing committee. The profitability of American business can best be attained through a group of well diversified, high quality, individual companies, held for the long run, or through a quality investment manager who can select those stocks for you.

3. The False Idea That The Wealthy Own Index Funds

I want to demonstrate that the vast majority of the wealthy in this country do not own index funds, and therefore if you want to attain wealth, it seems you shouldn't either. It is estimated that more than 80% of the stock markets wealth is held by the richest 10%.

So what do these titans of American capitalism know that you don't? Simply, that owning a business is very different from owning a fund which owns a small piece of 500 companies, where the committee which constructs that list of companies knows very little, if anything, about each company's worth and is buying them as a sampling of the economy, without any analysis of their value, profitability, etc. Of course I am talking about the S&P 500 index fund.

To be included in the S&P 500, a company must be located in the United States and have a market cap of at least $5.3 billion. At least 50 percent of the corporation's stock must be available to the public. Its stock price must be at least $1 per share. Finally, it must have at least four consecutive quarters of positive earnings.

Do you really want to pin your financial future on an index fund that chooses which stocks to own by committee using no analysis of valuation or price consciousness whatsoever? I certainly would not.

For wealthy investors who choose to own an index fund they would have to regard their own success as mere luck. The passive investment community would certainly regard any success in the investment arena as such, a mere matter of random chance. Warren Buffett is just lucky, as was Peter Lynch, John Templeton, Benjamin Graham, and a host of other well regarded investors over time. Seeing as most wealthy individuals are entrepreneurs or professionals, they would likely take this with great offense and articulate just how hard they worked to earn that wealth.

Therefore, every investor has to ask themselves the question; are you investing to make money, or are you merely trying to track an economy? The index funds objective is not to make money but to be a representative sample of all of the large cap companies in the US economy. Doing this in a passive way means that investors in such an index fund will capture every penny of downside when the market decides to go down because there is no one managing the holdings in the fund. Conversely you will make money based on a popularity contest of whose market cap is highest. In this way then, you own more of what is rising in price and less of those issues with lower market caps. How does this make any sense at all?

The wealthy make decisions based on real information about a specific business, their profitability, and their ability to compound wealth and produce free cash flow over time. They also tend to be more patient, willing to hold securities for a longer period, knowing that time and patience are the two most important factors in compounding wealth. This is backed by the most successful investors in history, such as Warren Buffett and Charlie Munger, who have routinely touted the benefits of long term buy and hold investing and have practiced it themselves:

"Charlie Munger put it in 2009: "This is the third time that Warren and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%." He went on: I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations." ...No true buy-and-holder has ever lost money; the vast majority of traders and market timers have. As Tolstoy said, "The two most powerful warriors are patience and time."

Irrational Markets and the Search for Skilled Managers

I have written several pieces to demonstrate just how bad of an idea it is for investors to buy index funds versus actual investment funds here, here, here, here, and here.

Now it is an even worse idea as market indexes have risen to ever loftier levels on tax reform and the prospect of accelerating growth. The fact that it does not concern market participants that everyone keeps piling more and more money into the same stocks is concerning in itself. We have seen these periods of prolonged disregard for value many times before in history as far back as the Tulip craze in the 1630's in Holland and again in the tech bubble.

The constant mantra of the index fund proponent is that prices are always correct, markets are efficient, and people act rationally when making decisions in the market place. But history shows us that this is untrue, that people tend to make decisions in an irrational fashion at times, pushing stock prices to bubble territory and selling them off to extremes as well. This herd mentality is a much more accurate characterization of market participant behavior. Investors for example who bought at the high in 1929 had to wait until the 1950's before recovering back to even; price matters.

Richard Thaler has won the Nobel Prize for Economics for his research in behavioral economics. A subject that has been relegated to the back corner of the economic landscape, as the efficient market hypothesis has formed the backbone of the financial world for many decades. Unfortunately in 2008, investors saw just how false the notions of market efficiency and the methodologies for managing risk really were. Index investing is a wonderful strategy for those in academia to prove their theories in worlds which have constant variables. However in the real world, an investor in the S&P 500 index who placed their money in the index fund at the turn of the century continues to underperform intermediate term bonds, even with a run up of over 300% since the 2009 lows.

This is a fact that continues to elude most investors, and yet index investing has grown to an increasingly dominant portion of the investment dollars entering the marketplace. The proliferation of bad active strategies has convinced many that active investing is simply not worth it. Instead it should motivate participants to do their due diligence on what works in investing over long time frames, and how best to invest.

Warren Buffett despite advocating index investing strategies, remains an active investor, and some would say is the best the world has ever known. Active investing practiced correctly (at low cost, low turnover, and high active share among other characteristics) can lead to demonstrable out performance over the long run.

I continue to believe that investors relying on index funds for their investment dollars are being lulled into submission to the failed notions that variances between a firm's value and their market price do not exist. Market efficiency is a concept that has validity to a degree, do not misunderstand me, however the notion that inefficiencies cannot, and do not exist, is a belief I have spoken out against, at times vigorously. There are numerous active managers who have tested positive for skill on a t-test, and further have a long and distinguished record of acting in their investors' best interest and outperforming the market. The t-test for those that are unfamiliar is a method that can be used to decipher between luck and skill when analyzing investment managers.

The book Investment Performance Measurement has a rather good description of the t-statistic and its usefulness in selecting investment managers:

"We isolate the value added to active management by subtracting the periodic benchmark return from the fund returns. Averaging the value added over a period of time gives us an indication as to the direction and magnitude of the value added. If value added was both positive and large over time, we might take that as an indication of the manager's skill. We can quantify whether or not the value added was significant (or not) by calculating the t-statistic for the value added. The t-statistic is a tool used in the branch of statistics known as inferential statistics. Inferential statistical tests calculate a statistic based on the data that have been collected, where the statistic can be used to infer the strength in the relationship between variables. For example, we are interested in knowing whether or not the value added by a manager is statistically different than zero. To determine this we set up the null hypothesis that the manager has added no value over the period; the alternative hypothesis is that the manager did add value, and we then use the t-statistic to try to prove the null hypothesis false." (p.205)

We can calculate the t-statistic through the following formula:

The author continues by offering an explanation of the interpretation of the t-statistic in making manager selection decisions.

The interpretation of the t-statistic depends on the number of observations used and the significance level selected. The significance level is the tolerance level for accepting that the manager has skill, when in fact he might not. In practice, a significance level of 5% is usually selected and the associated t-statistic required to reject the null hypothesis (that the value added is statistically undifferentiated from zero) is approximately two, depending on the number of observations...The t-statistic works by comparing the value added to that which we might expect to observe given the standard deviation of the value added. If the t-statistic is high enough that it is improbable that we would observe it by chance, we reject the null hypothesis and accept that the manager has added value over the period. If either the fund had outperformed the benchmark to a greater degree over a few short periods of time or we had many more observations of the same relative value added, we might have reached a t-statistic that allowed us to reject the null hypothesis. " (p.206)

Dr. Thaler's work further supports the contention of behaviorists who believe that the irrationality of market participants can drive prices on stocks to obscenely high and low levels creating opportunities to attain additional alpha through security selection and in depth research. The recent mantra that investors need to resign themselves to not being able to beat the market, and simply buy index funds, is misguided at best and downright dangerous at worst, exposing investors to the double edged sword of market momentum that could wipe out much of their gains by the end of this market cycle. Active managers on the other hand can sell overvalued securities and buy undervalued securities, they can go to cash when the market is too expensive, and they can, if their mandate allows, even buy bonds to cushion the impact of a market drawdown.

Conclusion: The Biggest Problem With Index Funds

The biggest problem with indexing is that it is very new in comparison to active management. The oldest index funds we have are S&P 500 funds that only go back to 1976, a mere 42 years. Compare this to active funds that we have more than 89 years worth of data on. The reality is that Graham and Dodd investing has worked for nearly a century and I believe it will continue to work because it is at the core of American capitalism. Warren Buffett himself wrote about the power of Graham and Dodd investing in The Superinvestors of Graham & Doddsville. If you haven't read this classic work I recommend it.

Index funds are not meant to make money for people, they are merely a way to track the aggregate of stocks through a sampling method. Real investing means considering what something is worth vs. what you can buy it for in the case of value investing, or buying a company that is compounding growth faster than peers in the case of growth investing, in both cases price is paramount to calculating overall investment returns. Index fund proponents seem to want to argue for a suspension of the laws of economics and continue to claim that price does not matter because market prices are always correct, and therefore bubbles can never exist. This is causing investors to continue with the failed notion that socking their monthly contributions into index funds will magically result in a comfortable retirement. This is simply untrue.

"The triumph of index fund investing means Vanguard's traders funnel as much as $2 billion a day into stocks like Apple, Microsoft and Amazon, as well as thousands of smaller companies that the firm's fleet of funds track. That is 20 times the amount that Vanguard was investing on a daily basis in 2009... through February of this year, nine out of every 10 dollars invested in a United States mutual fund or ETF was absorbed by Vanguard." NYT

The decision of active vs. passive could be substantial.

Source

Buying an index is not investing, it is speculating that the price of the index will be higher in the future than it is today. Because the index investor relies on the notion that markets are efficient, he does not concern himself with the fact that he may be overpaying for the businesses he is buying. He additionally gives no consideration whatsoever to what the firms he is buying are worth because he buys them all, the good and the bad.

Let's demonstrate how nonsensical it is to index. If you were blessed with unlimited sums of money and were going to buy real estate, would you say I am going to buy all the real estate in Detroit, as an example. Or would you team up with a great local real estate agent who knows the neighborhoods, and prices, and can help you focus your investments on safe neighborhoods with streets with big oak trees, and good schools? Investing in public businesses is the same philosophy. I want to "hire" managers with long track records, who have a disciplined process to manage wealth, and give me a good chance of earning a competitive return on my assets, either by buying companies that can multiply earnings growth faster than the average, or by buying companies for less than they are worth. This is investing, and it is what capitalism and America are all about; competition, free markets, and the ability to work hard and be rewarded for that effort with the possibility of a higher return.

Disclosure: I am/we are long TWEEDY BROWNE FUNDS, PRIMECAP FUNDS, AMERICAN FUNDS, DODGE & COX FUNDS.

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. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.