Young Canadian Investor #8 – The Downsides of Index Funds
Thanks to the efforts of the late, great, Jack Bogle, index funds have opened up the world of investing for everyday folks in a simple, cost-effective way.
Now, pretty much anyone can open a brokerage account, invest commission-free in a handful of index funds that own stocks all over the world, and thus piggy-back off humanity’s industrial might to improve their financial futures.
That said, these funds are not panaceas. Even though they’re the best option around for %99 of people fortunate enough to have spare cash lying around to invest, they are not without their faults.
1. Most index funds that track the stock markets of entire countries are market-cap weighted, meaning that the more a company grows in value, the more of its stock the fund will have to hold. The problem here is that, since stock prices are not only based on company performance but also on investors’ expectations about how companies will perform, investors’ expectations can and do frequently lose sight of how well or poorly a company is doing. That means stocks are often cheaper or more expensive than company performance merits. But the market-cap weighted index is designed to ignore these discrepancies and simply buy or sell in line with investors’ expectations without stopping to question them. One workaround is to integrate valuation into your investing process by considering which countries are cheaper or more expensive than others at any given time.
2. Because indexing has become so popular over the last decade, the investment companies that offer these funds have become increasingly larger owners of the businesses held by the funds. Right now, Vanguard, BlackRock, and State Street (The Big Three) own a little over 20% of the S&P 500 (the 500 biggest companies in the USA). That’s an issue because shareholders get to vote at company meetings to choose boards of directors and have their say regarding future plans. If you invest in an S&P 500 index fund, it’s the fund provider and not yourself that gets to vote for the 500 companies. If three investment companies basically have the reins of the USA’s capitalist machine in their hands, that smells of antitrust, and government intervention can’t be too far off. The Big Three vote in line with company management, so there’s been no rocking of the boat, but the door is certainly open for them to. We’ll see how long that lasts.
3. Another flaw to be mindful of is that index funds concentrate investor behavior. If you’re a stock picker or active investor, you’re going to own a handful up to maybe a couple hundred stocks based on your analysis of what a business worth owning looks like. If you buy into broad indexes, on the other hand, you buy into entire stock markets, including the outstanding businesses, the mediocre, and the ugly. So if an index fund investor decides to buy or sell a portion of their globally diversified holdings, they are essentially buying or selling a tiny part of every stock in every major index in the world, whereas the stock picker would only be buying or selling the specific stocks they own. In times of market distress, such as the virus-induced stretch we’re currently living through, it’s easy to see that a wave of selling from index investors can have an outsized effect on the markets simply because they own all of them. The more people index, the more pronounced this effect will be, and the more important it becomes to brush up on your investing basics so you never let fear get the best of you, and you recognize that, when index fund prices drop, that means they’re on sale, so you should buy more shares if you can instead of running for the hills.
In spite of their flaws, index funds still guarantee you the returns of the markets they track minus very low fees. They’ll also beat the vast majority of stock pickers over the long term, so long as you maintain regular contributions, choose an appropriate time horizon and risk tolerance, and keep your emotions in check. There is no doubt that everyday investors like you and me would be way worse off without them.
Disclaimer: This article is meant for general education purposes only. It does not constitute financial advice as I am unaware of your personal situation. Consult with a professional who abides by a fiduciary standard before making any investment decisions.