Index Funds Are Overrated

Virtually every single personal finance blog or book I read claims that index funds are the solution to all your money problems. Simply invest in an index fund and you will be rich.

Normally what happens is the person recommending index funds will claim that investing in passively managed funds is cheaper and less risky than investing in actively managed funds.

I think that index funds can be great (I use them myself) but there are many misconceptions people get from the index buy-and-holders that I feel I should warn you about.

1. Is the index diversified?

Many people say that investing in a single company is risky because that company could collapse. They then recommend you invest in a fund that tracks the S&P500 index. But the S&P500 index tracks the performance of only American companies. How can you be properly diversifying if you invest in companies that are headquartered in one country and there are hundreds of other countries whose companies you can invest in? What if national tax laws negatively affect American companies? What if the American economy simply collapsed?

2. Holding for the long run does not guarantee gain.

Many people say that if you buy-and-hold for the long run you will reduce risk. This is not true. There is no solid evidence for this. The companies that sell you mutual funds know they cannot give this guarantee so they tempt you by showing you long-run charts showing their investments going up over the long run to give you the impression that in the long run it will go up, but when you read carefully their contracts they always say, "Past performance is no indicator of long-term performance."

The reality is that perpetually rising index performance is dependent on perpetually rising company profits and perpetually rising company profits depend on perpetual technological innovation. How can perpetual technological innovation be guaranteed?

Many buy-and-holders often concede this, saying that of course there is risk in investing for the long term. But then they often say that they have incredible faith in business, in capitalism, in America, or whatever. Warren Buffett's line is, "It never pays to bet against America." I don't disagree with this. I think you should invest in whatever investments you strongly believe are undervalued. However, buy-and-hold indexers are not supposed to believe this. They are supposed to believe not in stock selection but in diversification. That is why they prefer indexing as opposed to selecting specific stocks. Likewise, if you want to diversify over time you cannot be a buy-and-holder because by doing so you bet on long-term success as opposed to short-term or medium-term success. If indexers believe in diversification they should diversify across time as well instead of just betting everything on the long-term performance of corporate America.

3. Laziness, not just greed, can create asset bubbles

The Great Recession of 2007-09 was triggered when the residential property market in American collapsed. Many citizens saw property values going up and up. "Property always goes up," they all said at barbecues and dinner functions. "Property doubles every seven years." "Property cannot go down." All these lies get passed around and people, driven by greed, invest in an asset based on ignorance. An asset bubble occurs when the value of an asset is above fundamental value. Price is above fundamental value if people investing in the asset are ignorant of its true value.

Just as greed can drive people to invest in poor assets, so too can laziness, which is how index funds can create asset price bubbles. Many people just lazily invest in index funds thinking it is an infallible investment. The problem has gotten worse lately as many retirement funds also invest in index funds, which mean that many average citizens invest in index funds without even knowing it. Because this investing is completely blind, prices are guaranteed not to reflect fundamental value since fundamental value requires people buy according to information about that asset and if people are lazy and just buy anyway, prices are bound to be higher than fundamental value.

This is most obvious when you look at the dividend yield of S&P500 funds. The Wikipedia article on the S&P500 dividend yield says the following:

In 1982 the dividend yield on the S&P 500 Index reached 6.7%. Over the following 16 years, the dividend yield declined to just a percentage value of 1.4% during 1998, because stock prices increased faster than dividend payments from earnings, and public company earnings increased slower than stock prices. During the 20th century, the highest growth rates for earnings and dividends over any 30-year period were 6.3% annually for dividends, and 7.8% for earnings. As of 2008, the average dividend yield is around 2%

Sure, investing in the S&P500 index fund would make sense when the yield is 6-7 per cent, but nowadays the yield is 2-3 per cent.

The chart below from Imarc.org shows how S&P500 dividend yields have gone down over time.


Now I do understand that not all indexers recommend you simply buy into a fund that tracks the S&P500 and then just leave it forever. Many now claim you should diversify into non-American stocks, into bonds, commodities, and so on. Many even recommend the Permanent Portfolio. But this is not how it used to be. I think many of the Bogleheads have become more conservative after losing so much money after the GFC.

I do think it's wise to diversify if you don't have information and you want safety, but if you're going to diversity you should diversify totally, which means more than just the S&P500. I only believe that you should totally diversify for money that you need, i.e. money you need to cover necessities like food. I believe that if you have quite a lot of money (a net worth of more than, say, $100,000) then you can afford to take on more risk, which means you should try to diversify less and, if you have time and think you're good enough, you should try to time markets or select good investments.

Mutual Fund Indexing Not Good for Believers in EMH

I have been reading some sites and came across the following:

Even if you are a die-hard believer in the efficient market hypothesis, that doesn’t mean you have to invest only in index funds. If the efficient market hypothesis is correct, then you won’t do any worse (on average) with a random collection of stocks within an index than you will by holding the index. If stock picking doesn’t matter, then you are free to pick any collection of stocks within the index that vaguely represents the index.

Some index funds perform poorly against the index not because they have high fees, but because they are trying to track the index too closely. When a stock is added to S&P 500, millions of dollars invested in S&P 500 Index funds must all buy that stock in order to track the index exactly. Stocks added to the S&P 500 do very poorly the year after this surge of automated buying. Funds that delay purchasing these stocks can perform better than those who purchase them immediately and pay a premium. Similarly, stocks that are being removed from the S&P 500 will out perform the index over the next year because all the index funds dumping the stock drive the price down needlessly. Delaying the sale of this stock until it has had a chance to recover produces superior returns.

Source: How to Blend Index Funds

Here's my situation. I suspect that buying individual stocks yourself can be cheaper than investing in index mutual funds or ETFs because holding individual stocks doesn't eat up any management fees. You have to pay brokerage fees to buy the stocks, but you only pay once rather than annually, so that over the long run (30 or 40 years) your costs are virtually zero.

There are exception to the rule here. Many foreign, high-cost investments should be accessed using ETFs, such as emerging markets or frontier markets. However, if your discount online brokerage offers $20 trades to buy stock in domestic companies, I think that replicating the index yourself can save you money.

One problem is trying to constantly sell and buy once companies go off and on the index. This problem comes about because indexers set an arbitrary line between big and small companies. Many choose the S&P500. But why the top 500 companies? William Bernstein in The 15-Stock Diversification Myth claims the following: "Fifteen stocks is not enough. Thirty is not enough. Even 200 is not enough. The only way to truly minimize the risks of stock ownership is by owning the whole market." The whole market means the whole market, not the S&P500. It means everything, from small caps to large caps.

What I suggest then is using ETFs to cover the high-cost areas and for the low-cost areas, randomly sample from a population of all stocks using market cap as weight. Over time, as you buy, your cumulative sample will converge towards the market.

DIY (do-it-yourself) indexing will give you identical expected returns to an index mutual fund but because DIY indexing carries significantly lower costs, it follows that DIY indexing will beat index mutual fund investing over the long run in the same way that index mutual fund investing will beat active mutual fund investing in the long run (mainly because of fees).

STW Versus ASX20

Many people buy STW on the Australian Stock Exchange if they want to buy an index fund that tracks the S&P/ASX 200. While on Ninemsn, I looked at the recent five-year performance of STW and then compared it to the performance of the ASX20 index. What I found was that there is a difference but the difference is quite small, and the ASX20 actually beats STW in this instance. This makes me wonder whether it's worth it to buy an index fund like STW and pay MER of 0.29% when I can easily build up a collection of 20 stocks that replicates the ASX20 using a broker like Commsec for a lot less. If I have a lot of money invested, even if I put half in an index fund and half in direct stocks that replicate an index, I am sure I can save a considerable amount in management fees and not have that much impact on investment performance.

Vanguard Too Expensive?

I invest in a mutual fund from Vanguard Australia. Vanguard loves to talk about how cheap its index funds are. They are right in that their index funds are cheap compared to mutual funds from big, well-known companies like Colonial First State. The problem is that they aren't cheap compared to direct share ownership or ETFs. Vanguard in the US provides ETFs, but Vanguard Australia doesn't. Vanguard Australia's MERs are also quite high. I pay 0.9 per cent per year. I am starting to believe that if I purchase shares directly I can replicate the broad market myself while paying zero management fees.

Some people argue that DIY indexing is more expensive because, for example, if you wanted to replicate the S&P500 (probably the most replicated index in the world) you would have to buy shares in 500 different companies and you would have to constantly buy and sell as companies go in and out of the index. The whole idea of indexing is that you follow an index. What makes one index better than another? For example, you could use the S&P500, but you could also use the Dow Jones Industrial Average (DJIA). In Australia, you could use the S&P/ASX 200 but you could also use the S&P/ASX 300 or even the broader All Ordinaries. Who ever said that 200, 300, or 500 is a sacred cut-off number? If you hold 500 companies, in reality if you added 100 more there wouldn't be much difference because each marginal company you add has a relatively small market capitalization. At some point you are overdiversified. If there is no such thing as overdiversification, then why do indexers only hold the top 500 or top 200 companies in a country? Why not hold every single company in the country or the world? I think that holding the top 20 companies is enough, but if you want to go further you can easily, and the costs will be lower if you held them directly. I think that if you factor in costs of diversification you can use calculus to derive the optimal number of companies to hold. William Bernstein claims that the best option is to hold "every single company" but I doubt he actually holds every single company in the world. If you're an indexer, you hold an index, which is a selection of companies.

Of course, companies change. Some top performers fall from grace. For example, Enron collapsed. If a certain company falls from an index, the index fund manager will sell the shares. The DIY indexer can do the same.

I happen to think that minimizing cost is more important than strictly following an index. Strictly following an index I think is quite dogmatic. I recommend buying randomly using the top companies (using market cap as weights) and then every now and then superimpose the performance of your portfolio onto to the index to see if it roughly matches. You could use statistical techniques but I think just eyeballing is enough. By doing it yourself you pay zero management fees. Vanguard argues that costs matter. If you believe them, you should ditch them.

It is true that you pay brokerage fees for buying stocks directly but you must also remember that Vanguard has a buy spread. As long as you're not putting in small amount all the time, you should be okay.

Index Fund Versus Hedge Fund

I've just read Buffet's Big Bet from Fortune Magazine.

Warren Buffet, the world's richest man, claimed that he was willing to bet one million dollars that ten hedge funds cannot beat an S&P500 index fund from Vanguard.

A hedge fund from New York called Protege took this bet up. If Protege wins the bet, the money will go to Absolute Return for Kids, an international charity that helps children. If the hedge funds from Protege do not beat the S&P500, the money will go to Girls Incorporated of Omaha.

What I'm unsure about is why Buffet chose the S&P500 index. Buffet has said many times that he believes the future of the American economy is bleak. He claims that he is now looking for opportunities outside of America. E.g. he made a lot of money buying stocks in PetroChina, a company many accuse of human rights violations in Darfur, Sudan. My understanding of hedge funds is that the hedge fund managers have a lot of freedom to invest the money however they want to invest it without the burden of having to comply with too much regulation. Therefore, if Buffet believes America is in for a bleak economic future, he was unwise to use the S&P500 index as a combatant against the hedge funds. Instead he should have used the MSCI World Index.

Today the US economy makes up about 40 per cent of the world economy, which is very significant. However, in the future, emerging markets are expected to rise. Hedge funds have the freedom to invest in these emerging markets while the index fund that tracks the S&P500 cannot.

Using Index Funds to Hedge Against Rising Petrol Prices

The rising price of petrol is making news here in Australia where petrol is reaching unprecedented highs of $1.60 per liter. I drive to work and to the train station to go to university. I also drive my grandma around sometimes. I fill up approximately every fortnight. I pay approximately $70 each time I fill up. Since my parents fully subsidize my food and accommodation costs, just about all my spare money goes to petrol. It is by far my biggest expense. Crude oil futures on the New York Mercantile Exchange is about $130 per barrel now.

If I lived in the United States it would be easy for me to buy oil ETFs (AMEX:USO) that would go up in value as oil goes up in value. It'd be as if I'm buying barrels of oil on the stock exchange. But alas I live in Australia so access to American investments are complex and costly. Investing in American crude oil is not a perfect hedge against rising petrol prices in Australia because crude oil and refined petrol are different products. Exchange rates between the Australian dollar and US dollar would also add another layer of complexity.

How then can I hedge against the rising costs of petrol? One of my friends jokingly told me to buy a bike. With the distances I have to travel this is just not practical. Plus I'm scared of loud trucks. Hopefully with higher petrol prices these loud trucks will go out of business.

Another idea is to invest in the resources, energy, or materials sector. One of the best performing and one of the most popular managed funds in Australia today is the Colonial First State Global Resources Fund. In the past year it has given investors a return of 27 per cent. In the past five years the average annual return is 30 per cent. Looking at this fund's top ten holdings, I notice that there are many familiar Australian faces like Rio Tinto, BHP Billiton, Xstrata, and Lihir Gold. There are also some Canadian companies in there like the Potash Corporation and Nexen. Instead of investing in the high-cost actively managed CFS Global Resources Fund, why not invest in an index fund that tracks the top Australian companies? This may work since Australia's top companies are heavily biased towards the resources and financial sectors. The financial sector is the largest sector in the MSCI Australia Index, making up approximately 40 per cent of the index. However, together the energy and materials sector make up 35 per cent of the index, which is quite a lot. Simply by investing in, say, the Vanguard Index Australian Shares Fund or the SPDR ASX200 ETF, you can probably get good exposure to Australian companies that deal with commodities.

Why just look at Australia? The MSCI Emerging Markets Index is very heavy with commodity companies, many of which are state-owned. The energy sector makes up 17.04 per cent of the MSCI EM Index while the materials sector makes up 12.99 per cent of the index. The energy sector and materials sector make up 11.39 per cent and 8 per cent of the MSCI World Index respectively, which is relatively low. This suggests that if you want exposure to resources companies, go to the emerging countries and Australia.

It is not that simple. Just because you invest in companies that deal with commodities, it doesn't mean you've hedged yourself against rising commodity prices. The cost of mining and transport might be higher, which may affect profitability. Even though commodity prices go up you may simply be investing in a bad company with bad managers and bad workers. Furthermore, many of these resource companies may specialize in gold, silver, and materials like iron ore. These may have little if not anything to do with oil or petroleum.