Seeking Alpha

These Are Not Good Indexing Criticisms

by: Cullen Roche

As indexing becomes more and more popular, it is also coming under increasing fire. I've written a lot about some of the more common indexing myths, but I also wanted to discuss a few myths and misunderstandings that have become more common in recent months:

1. Index funds are increasingly exposed to tech and therefore don't diversify investors

This one was front and center in a Barrons article last month. The basic argument is that equity index funds are turning increasingly into big technology funds. It's true. As the US economy becomes more heavily tech oriented, the stock market is also becoming increasingly tech oriented. And while this exposes equity investors to more technology risk we should be very clear about something:

ALL STOCKS ARE VERY RISKY

Yes, I was screaming that. The reason I screamed it is because there is this nefarious myth out there that you can "diversify" INSIDE the stock market. This is misleading. The reality is that all stocks are very risky. Even though we call some stocks "defensive" stocks or "low volatility" stocks, the reality is that all stocks are volatile when it matters most. For instance, in a year like 2008, utility stocks fell ~50% despite being considered the most defensive sector in the US equity markets. Dividend paying stocks, commonly thought of as being safer equities, fell ~60% in 2008. The point being that there's no such thing as "safe" equities. When the shit hits the fan almost all equities go down significantly and you very likely won't be able to pick which ones don't go down a lot in advance.

This is why real indexers diversify OUTSIDE of equities. The only way to guarantee uncorrelated performance when equities are in a bear market is to own assets outside of the stock market.

So yes, the increasing value of tech stocks means the equity markets are becoming more exposed to specific tech sector risk. But that does not mean you can't diversify that risk away by properly indexing with assets like bonds.

2. Index fund companies are bad because they own "sin stocks"

I don't love the idea of "sin stocks". After all, "sinning" to one person is normal to another. As long as it's legal, no corporation is a "sinner" to its customers. They are actually the provider of a valuable service.¹ Saying that it's a sinful service is imposing your values on other people in what our overall society considers to be a sinless activity (otherwise it would be illegal).

I write this in response to a Parkland shooting activist saying that we should boycott Vanguard and BlackRock because they own gun stocks in their index funds. But this seems to be a misunderstanding of how the index funds actually work. You see, Vanguard isn't really in the business of picking gun stocks. For instance, when S&P constructs the S&P 500, their rules based system for picking stocks might include a gun stock. All Vanguard does is then take the index that S&P constructed and they mimic it in their own index funds. And since Vanguard is really popular they end up being a big shareholder in gun stocks even though no one at Vanguard sat down and chose to own gun stocks.

Now, you might say that Vanguard should remove the gun stocks from their index funds. No, they shouldn't because then they wouldn't be offering the index that they are in the business of offering. They'd be offering something different. And a big part of Vanguard's "passive" investing appeal is that they don't make discretionary decisions like this.

Anyhow, part of the nice thing about working from an operational understanding of these things is that we are able to rise above the politics that often cloud these conversations and see the world for what it is as opposed to seeing the world that some biased people want us to see.

¹ - I will make an exception for cigarette producers here. These companies knowingly sold cancer causing products to their customers and intentionally tried to cover it up.