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Why I Won't Invest In Index Funds Like SPY And QQQ

Kiplinger magazine did me a favor and pointed out the problems with index funds like SPY and QQQ. The stocks those indexes pick are the top 500 (or 100 in the case of qqq) stocks based on market capitalization. So if there are stocks with artificially high market capitalization due to some fad (like dotcom), index funds pick them and really get clobbered.

For example, look at the losses for SPY during the dotcom bust:

Year.....Pct Return
2002....-21.4978
2001....-11.7873
2000....-9.6562

And here's QQQ

Year.....Pct Return
2002....-37.3683
2001....-33.3448
2000....-36.1149

The ending price for SPY was 146.88 in Dec 1999. SPY never got back to that price again until the end of 2007 and then we had the mini depression! QQQ was even worse. The price for QQQ didn't recover until 2015!

In contrast, look at something like FLPSX:
Year.....Pct Return
2002....-6.1269
2001....25.9516
2000....17.977

While SPY and QQQ continued to lose money year after year in 2000,2001, and 2002, funds like FLPSX and JSCVX made money on two of the three years and only lost a relatively small amount in the 3rd year. And the prices for FLPSX and JSCVX recovered in 1 year, not 8 or 15 years like SPY and QQQ.

Should you buy funds like FLPSX or JSCVX then? Maybe, but not necessarily. They have managers with certain stock picking styles. When those managers leave, the new manager may or may not do as good at picking stocks.

A smart Beta fund, in my mind, could be better. Their indexing method eliminates the problems of stocks picked based on market capitalization. And because they have a fixed, defined stock picking method, it doesn't matter when a manager leaves the fund. The stock picking method should remain the same. ETF's like EZM, SCHD or OUSA are examples of ETF's that eliminate the market capitalization problem.

Disclosure: I am/we are long EZM, FLPSX, JSCVX.