Why Index Funds are Bad Investments
September 1st, 2008 | Published in ETFs, Index Funds, Investing 101, Mutual Funds, Retirement | 30 Comments
The entire personal finance blogosphere is in love with index funds, and I’m here to tell you why they’re bad for your investment portfolio.
This should go over well. Black sheep anyone?
I realize this thesis will not be a popular one, but from my perspective as an active investor and stock picker, I’m here to tell you that index funds have essentially been dead money for the last decade.
So why do bloggers constantly recommend index funds?
- Index funds are very easy to understand.
- They likely know little to nothing about the stock market.
- They don’t want to recommend individual stocks or mutual funds for fear of reprisals.
- It’s an easy answer to a difficult question because index funds require little to no research whatsoever.
- Everyone recommends them, so they feel safe passing along the same recommendation as the rest of the herd. So if the market tanks, they got fooled like everyone else and everyone likes to fit in.
Pretty tough critique of my comrades to say the least, but I think that is a fair assessment.
Naturally, everyone will say “Why are you speaking such blasphemy about our beloved index funds?“ Easy. Pull the stock charts and check the research my friends!
Below is a very simple overlay chart of the S&P 500 (the most popular stock index to track) compared to the CGM Focus Fund managed by Ken Heebner, who was voted Morningstar’s Top Fund Manager of 2007. Just give that chart a few seconds to soak in.
Heebner’s CGM Focus Fund is up 320% in the last decade compared to the S&P’s lackluster 25%. Shocking isn’t it?
Take note that the S&P 500 index fund did not return 25% each year, but only 25% in the last decade. Considering that gas prices have doubled (maybe more) and food inflation has skyrocketed in 2008 alone, it’s a plausible argument that a 25% return over 10 years won’t keep pace with your spending requirements in later life.
I expect better for my money, and so should you!
Now, depending when you began purchasing shares of the S&P 500 index fund (one lump sum purchase or a consistent dollar cost averaging purchase plan), you would almost certainly have a different outcome. For example, if you began accumulating shares 2003, you could be up as much as 50% for those particular purchases. A very respectable return.
Conversely, had you made a single lump sum purchase in mid 2000, you still have a net loss 8 years later.
The major point being, if you purchased shares from 1998 to 2008 on a consistent dollar cost averaging basis, you would see very little, if any realized profits on your total balance. You may even have a negative return once the full numbers are calculated!
If you have spent any significant time researching the stock market over the last decade, or you just enjoy reading personal finance blogs, you have ostensibly found that index funds have become the core holding in the so called “lazy man’s portfolio“.
To put it simply, an index fund investor is essentially buying a very diversified group of stocks all lumped into a nice, neat, no nonsense package with very low expense ratios.
However, like any diversified object, you often get the slackers in addition to the high performers.
Take for example, your high school graduating class. You had the brainiacs taking AP Calculus on one end of the spectrum, but you also had the kids who barely graduated. By basic bell curve statistics, you are left with a large group of average performers pulling a 2.0 grade point average.
Same thing with buying basic index funds - you get some good, some bad, but mostly average performing stocks.
That’s fine if you want to want to travel within the safe confines of the herd and make average returns based upon broad market sentiment and the economic outlook of the U.S. Stock Market (or global economy if you buy foreign index funds), but considering the overlay chart above… do you really think that index funds are your best option?
Probably not.
How do I make my money work harder?
- Pick mutual funds with an excellent track record of out performing the S&P 500. Any website like Morningstar, Kiplinger’s, or blogs like mine will always cover the better performing mutual funds and exchange traded funds (ETFs).
- Setup an account with a full service brokerage firm. These are more expensive, but like anything, you get what you pay for.
- Hire a financial planner. If you are looking for more better than average returns, let him/her know your goals and it’s just that simple.
- Ask for advice from a trusted colleague/friend with investment experience. I learned how to invest from a family friend, and it’s one of the best financial moves I ever made.
- Do it yourself and build your own mutual fund. There are many websites and blogs that cover mutual funds or individual stock research, so grab a few RSS feeds, do your own research, and away you go. Just make sure you know what you’re doing, and start small in the beginning.
Now, tell me honestly, can you make a case why your diversified index funds can hold a candle to professionally managed mutual funds with an excellent fund manager who has consistently outperformed the broad market?
- High expense ratios. True, costs will eat into profits but when you have a fund outperforming the broad markets, you are getting what you pay for.
- No Load mutual funds. I would never buy a load containing mutual fund, and anyone who does is throwing away money. They are a horrible remnant of old world investing, so avoid them at all costs.
- Automated investing. Almost any mutual fund has an automatic investing plan available.
- Less risk. It’s true that some mutual funds can be risky investments, but that is where your own research comes into play or that of your investment adviser.
To sum it all up, I’m not suggesting that index funds are horrible investment choices and should immediately be sold if you own them. Not at all, because I own index funds in my own retirement accounts.
I’m merely pointing out that you shouldn’t close off the possibility of owning several traditional mutual funds or ETFs that have superior historical returns. By allocating a certain percentage of your overall portfolio to higher risk investments, your returns could potentially be far better than using index funds only.
Who knows? Perhaps one day in the future, you might actually be able to buy one of those $4 coffees without all that self loathing, self indulgent guilt!
Photo by Erin_T at FlickR
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September 5th, 2008 at 9:09 pm (#)
[...] Why Index Funds are Bad Investments - Matt calls us “personal finance” bloggers out on the herd mentality of constantly recommending Index Funds. I’ll admit, I am guilty of this in my own book, though I lean more towards ETFs than Index Funds. In fact, I leaned as far away from specifically recommending anything to anyone as I could! (Yeah, I’m cowardly that way, but I’m also not a financial advisor - just a writer that got lucky on a book deal ) I had pretty much discounted Mutual Funds completely though, so I learned a bit with this article. [...]
September 7th, 2008 at 7:35 am (#)
Good article and comments. But I think the trend is for less diversification and more toward solid value assessments in building a winning portfolio. It seems a lot of investors, tired of diluted gains, are starting to latch onto the whole movement around value-based investing.
September 7th, 2008 at 7:51 am (#)
@ Stock Research
Thanks. I agree folks are picking up on the value investing trend, but I think the main point that I wanted to make was not to overlook performance just b/c you’re hung up on low expense ratios. As long as I’m getting what I’m paying for, I’m a happy camper.
Those people who really cleaned up in the last 30 to 40 years made their big money by picking exceptional companies and avoiding the laggards. This coming from someone who has been sitting on index funds for the last decade and basically making no money, so it was an observation from my own portfolio.
September 9th, 2008 at 2:50 pm (#)
Aha! Your post confirmed my suspicion that my index funds suck. They’ve trickled in some returns over the years, but quite frankly, I’ve been doubting the ability of the funds to do me any real good. I agree with what you said re: index funds being “safe” and easy to explain. This is precisely the investment paradigm I’m working to break out of. Easy and safe doesn’t seem to make much money.
September 9th, 2008 at 3:42 pm (#)
@ Drea
Precisely! Bill Gates or John Chambers didn’t get rich by being diversified. Now, you and I probably are not sitting on a few million shares of a company we created, but with risk comes reward and they’re good examples of that.
General rule of thumb says be diversified in the majority of your accounts but it never hurts to speculate with 25% of your portfolio.
September 10th, 2008 at 12:32 pm (#)
En Garde!
http://socalsavvy.blogspot.com/2008/09/en-garde.html
September 10th, 2008 at 4:52 pm (#)
Ahhh… faulty logic it is when you ignore the rule of regression to the mean!
It’s nothing personal; I think we’re just arguing about different time frames. Over the long run, which retirement planning for 25-year-old is, the data shows that very few mutual funds will beat the market. Some will, of course, but divining which ones those are is hard.
I’d say that while many companies are multi-national today, there is ample proof that adding large and small cap international indexes brings down the risk in a portfolio while adding additional unique return. With the advent of the internet, no one is confined to the US markets. Therefore, I see no weakness with indexing due to that point.
I think you are smart to write the article!
It makes people think about the methods they choose to invest in and the underlying assumptions they hold. Please don’t think I’m picking on you, we’re just both expressing opinions based on the lessons we have learned (professional or academic- both have their merits).
The only thing that I think you were guilty of was being a little harsh in tone! If you want to suggest an alternative point of view, it’s not nice to project anyone’s demise.
See the problem with the dates you picked (although with good intentions, being 10 years from your post) is that they happened to be good years in general.
I’d say try running the same scenario with mutual funds over 40 or 60 years- timelines that retirement portfolios use (although that would be impossible with your current mutual fund pick as it is only a decade old).
So I guess the only thing left to clarify is: is 7% returns dead money? What about 10-13%? What do you think a person should expect of their portfolio returns and at what risk?
September 10th, 2008 at 6:41 pm (#)
You sound like a lover of statistics… no wonder I’m having a hard time swaying your logic. While I’m a HUGE proponent of the numbers, investing doesn’t always follow the numbers. That’s a big admission b/c I’m a former pharma consultant, so I can obsess about importance of P values until I’m blue in the face.
I’m sensing your hesitance is about picking a mutual fund or individual stocks on your own. A very common problem, but that is where knowing how to do the research to pick the winners or hiring someone to do the research is in your favor. Which is why I suggested for those who can’t do them on their own, hire someone that has a history of outperforming the broader markets. That said, you have to sort out the posers and shovel through the BS to find the real keepers.
I’m not sure if anyone has beaten the major indices every year, but I don’t think it’s realistic to set that high of a standard. Would you bench Kobe Bryant for going 7 of 10 from the foul line? Probably not. But you have to acknowledge the fact that some stars shine brighter than others, which is why picking the right people to run your money works in your favor.
As for an annual 7% return, that is acceptable on a long enough time horizon. Problem is, you can get single digit returns like these in the bond market. Heck, I’ve got 6.0% on my savings account, which obviously won’t last forever, but can be found quite easily in fixed income market. Guy’s like PIMCO’s Bill Gross do very well.
I don’t mean to continue bringing up the 10 years issue, but many people suggest that including the great bull market of the past is a serious liability. America has strong odds going against this type of growth period b/c lets face it… history shows those types of bull run markets are very difficult to continue over a long time horizon. I’m certainly not putting my faith in having another one. I’m looking elsewhere to other international markets for those types of returns.
If you’re only 25 years old, any financial planner would tell you shoot for higher returns in a high risk, but diversified, portfolio. Probably something in the small cap or mid cap companies with strong growth prospects.
September 13th, 2008 at 11:02 am (#)
[...] Finance has the perspective that index funds are bad investments. I can’t say I agree with everything here, but it gives thought and reminds us that we should [...]
September 13th, 2008 at 11:53 pm (#)
Hi, I wouldn’t have bothered to reply but the “trolling” title of this post on Carnival of Personal Finance prompted me to speak up. Nobody’s making you invest in index funds but it is irresponsible to say they are a “bad investment.”
Here is what one of my favorite financial gurus, Scott Burns, says about Index vs. Managed Funds:
**********Begin Scott Burns quote*************
The best way to get a grip on this is to read one of the SPIVA reports, a quarterly report from Standard & Poor’s that measures the performance of managed funds against major indices. Unlike most reporting, this one adjusts for survivor bias. Here’s a link to the most recent report: http://www2.standardandpoors.com/spf/pdf/index/SPIVA_2007_q1.pdf . As you’ll see from the report, active management doesn’t come out very well and they are only measuring a 5 year period. The longer the time period, the greater the odds that the index fund will beat managed funds.
. . .
This report verifies research I have been tracking since the early 70s. This research, done by a multitude of different parties, has consistently concluded that about 70 percent of all active managers fail to beat their appointed index benchmark. This doesn’t mean the 70 percent figure is consistent, it actually moves up and down over long cycles. But the general range is from about the 50th percentile to the 90th.
In rising markets the index funds have an advantage over managed funds because they have little or no cash so they get 100 percent of a rising market. In declining markets the index funds have a disadvantage for the same reason— while active funds hold more cash and are slightly less vulnerable to declines, index funds feel the full drop.
Scott
****************end Scott Burns quote ******************
September 14th, 2008 at 12:04 am (#)
I own index funds myself (had you read the article) but my S&P based index fund is my worst performer.
Your own research states 30% of MFs beat their index benchmark. I’m saying if you do your homework, you can find these managers yourself and come away with a far better return.
September 16th, 2008 at 9:55 am (#)
[...] Finances - Why Index Funds are Bad Investments. A different point of view on a type of investment vehicle that’s gained favor with [...]
October 7th, 2008 at 11:52 pm (#)
[...] made no secrets about my views of index funds being bad investments because the poor performers, particularly in the S&P 500, will tend to weigh down any [...]
October 13th, 2008 at 5:23 pm (#)
Just curious what savings account you have that was returning 6% as of 9/10? Just curious b/c according to bankrate.com, there isn’t a savings account close to that now. I realize that the rate has dropped recently, but nowhere near enough to bring it down from 6% to the mid-3% rate that you can find now.
October 13th, 2008 at 6:36 pm (#)
@ Brad,
I’m using a bank I found through http://www.CheckingFinder.com. Searching for the highest rate, I found a small bank in Missouri. It requires you use a debit card 10x a month and 1 direct debit/deposit per month. Which in most cases, is fairly easy to accomplish.
I love bankrate.com, but it occasionally misses the smaller banks. Which is why CheckingFinder.com works so well - at least in my case.
Let me know if it works out for you.
October 14th, 2008 at 4:52 pm (#)
yeah, owning actively managed funds is better. if you own a time machine.
nobody ever claimed that an index beats every managed fund in every time period; just that a) the appropriate benchmark index fund will beat the overwhelming majority of actively managed funds over periods longer than 10 years, and b) nobody can reliably identify the small number of funds that will outperform. though there _is_ one strong indicator of a truly superior managed fund: it will be closed to new money.
on the other hand, it is hard to make a graph out of this line of reasoning, so lots of people will continue to ignore it.
October 14th, 2008 at 6:28 pm (#)
@ misanthropope
There are a few good managers out there, and yes I agree, finding them is becoming more difficult due to any number of factors. Then again, difficulty is intensified when the search for a good manager begins with determining if he/she lost less money than the comparable index, as the case in 2008.
One other thing to consider is that the S&P 500 is essentially a mutual fund in itself. Standard & Poors decides who gets in or out based on the decisions of a committee - just like an actively managed mutual fund.
October 21st, 2008 at 3:43 pm (#)
[...] If you have been reading this blog for a while, you would know I’ve been rather outspoken on index funds calling them bad investments. [...]
November 10th, 2008 at 10:26 pm (#)
Interesting … never thought of it that way.
I always assumed index funds were great investments.
November 10th, 2008 at 10:52 pm (#)
@ TStrump
Thanks for commenting.
My opinion certainly isn’t a popular one, but it’s an interesting way to dissect the S&P 500 index. I’m a trader so being a passive investor is difficult for me to absorb, but make your decision on picking actively managed funds very carefully if you go outside of the passive realm.
Vanguard also has a few managed funds that held up reasonably well.
December 16th, 2008 at 11:56 pm (#)
[...] for your livelihood, with little to no chance of re-entering the workforce. I’m certainly no fan of index funds, but I would rather see poor returns than no returns at [...]
January 1st, 2009 at 12:33 am (#)
“There are a few good managers out there”
——————————————–
Up until a few years ago, Bill Miller was considered among the best in the business.
Unfortunately, most people started moving into his fund after his success [major inflows began in 1997, the 7th year of his 15 year streak] and before his failure, usually called return chasing. These people have now underperformed against the S&P during this time frame, largely helped by his huge holdings of BSC.
As for picking mutual funds, they are a scam. But, don’t take my word for it. Listen to what Jack Meyer, the former president of Harvard Management Company had to say:
http://www.vanguard.com/bogle_site/sp20060406.htm
“Most people think they can find fund managers who can outperform, but most people are wrong. You should simply hold index funds. No doubt about it.” ”
David Swensen, CIO of Yale University Endowment fund says:
“A minuscule 4% of funds produce market-beating after-tax results with a scant 0.6% (annual) margin of gain. The 96% of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8% per annum”.
And William Bernstein, author of 4 Pillars of Investing says:
“While it is probably a poor idea to own actively managed mutual funds in general, it is truly a terrible idea to own them in taxable accounts…taxes are a drag on performance of up to 4 percentage points each year.
Bogle’s book, Common Sense Investing [c. 2007] dissects managed mutual funds going back to 1970 [following information gathered from pages 79-88 of this book]. There were 355 managed funds that were in existence at that time.
223 of them have gone out of business. 15 of them beat the market by 1% and 9 others have beaten the market by more than 1% [2.5%]. Those 15 funds that have beat the market by 1% will more than likely charge approximately 1% or more than an index fund, making their return over the S&P nil.
But, the problem with these 9 funds with superior returns is that 6 of them achieved their superior returns BEFORE large money poured into the funds. They have been lackluster since. 3 funds out of 355, that’s it - less than a 1 in 100 chance.
Now, if you truly believe as an investor that you are capable of beating the market as a whole over the long run and are willing to put in the effort to back up that belief, then I would fully support someone doing that. I don’t agree with it personally but if someone is willing to accept the risk themselves then it is what it is.
However, I would absolutely never, under any circumstance recommend ANY actively managed fund to someone for long term investing.
Nor would I personally want to spend so much time for the necessary research for the slim possibility that I will beat the market as a whole over the next 40+ years.
Do I think that most people, that independently manage their own portfolio, will be successful? No. I believe you have less than 1 in 100 chance of being successful if you are of high intelligence - say close to genius, and dedicated to the effort and research necessary. Otherwise, I recommend index funds to everyone else. If only 3 out of 355 professionals can do it with their research and access to information then I have little confidence that a non-professional can.
Therefore I will enjoy the most passive form of investing that minimizes my expenses [both management fees and taxes] and allows me to enjoy almost all of the total market returns and accept that I am in the 85th to 90th percentile in terms of investment returns earned by investors as a whole.
Call it lazy, I call it common sense.
January 1st, 2009 at 1:52 am (#)
So let me get this straight… you prefer to own the C+ and below the bell curve performers in your portfolio? Who in their right mind was buying financial companies — a major component of the S&P 500 — in 2008?
Most of us who trade for a living were shorting the financials every chance we got until the short sell ban was enacted, and then we just shorted the SPY or bought the ultra short financial ETFs (e.g. SKF), which of course, crushed anyone who owned index funds. So why would you knowingly want to buy something with that much short interest and had every indication of getting creamed or having their stock price eroded down to zero? Think Lehman Brothers or Bear Stearns.
This is probably my biggest argument against index funds — because there
isare a few bad apples in the group that will ruin the bunch. Just like financials did this year, and why I was chastised when I first wrote this post in September.Index funds are doomed to suffer the same fate as the perceived strength of the American economy. And for the reversion to the mean argument, it’s my contention that most of the rise in the market during the 1990s and 2000s were essentially bubble based and built upon leverage. Pull a chart of the S&P 500 from the 1950s until now (make sure it’s linear, not logarithmic).
The meltdown in October was an excellent example of this wouldn’t you agree? Try finding an investment bank out there today who’s willing to take on a 30 to 1 leverage ratio betting on the market and inflating stock prices.
As for your research, I do agree with 90% of it. I am a partially passive investor since I own index funds myself in my IRA, so that if I’m wrong, I don’t totally screw myself. But as you can see, I’m willing to do the hours of necessary research and I actually have profits this year unlike most people.
You’re exactly right that most mutual fund managers couldn’t find their butt with 2 hands and a flashlight, but that’s because (in my opinion) managers who don’t outperform over an extended period of time simply don’t know how to trade.
I’m not talking about market timing, but I’m talking more about the ability to rotate out of sectors that are overvalued and into undervalued sectors. My best example of this was during the tech bubble of 2000 when Kevin Landis was holding semis at P/Es > 500 or dot coms with P/Es in the negative 10,000 arena. Ken Heebner’s CGM Focus Fund did the same thing by staying overweight in commodity stocks far too long in mid year. Once the technical breakdown in the oil market occurred, it was a clear warning sign to sell or get short.
You are also correct that it is increasingly difficult to trade once you become a multi billion dollar fund. I imagine it’s difficult to disguise blocks of 50,000 to 500,000 shares on an electronic exchange without raising some eyebrows.
However, I’m not willing to completely give up on actively managed funds. Perhaps one of the biggest problems is that the best money managers have been chasing hedge fund salaries and performance bonuses. You have probably heard about a few that imploded this year, but there are a few who did well. Sadly, one of the best decided to abandon the business (Andrew Lahde - profits up 1000% or so) and write a tirade why smoking pot should be legalized. Go figure!
Thanks for your comment!
January 15th, 2009 at 11:59 pm (#)
[...] before the index fund lovers call me a black sheep for speaking ill of the S&P 500, just know I’ll likely suffer in a downturn with you [...]
January 19th, 2009 at 9:13 pm (#)
[...] actually have to do our own research and pick a few successful companies instead of relying on index funds poor performance to finance our [...]
April 2nd, 2009 at 5:33 pm (#)
hot air
April 2nd, 2009 at 7:00 pm (#)
@ Tom
please elaborate.
April 6th, 2009 at 11:22 am (#)
This advice is really going to help, thanks.
April 6th, 2009 at 11:35 am (#)
No problem. Glad to help!
April 21st, 2009 at 10:42 pm (#)
[...] index funds — like one Jim Cramer last week — is black sheep territory (been there, done that), but I came across an interesting observation [...]