Steadfast FinancesWhy Index Funds are Bad Investments - Steadfast Finances

Why Index Funds are Bad Investments

Filed in ETFs , Index Funds , Investing 101 , Mutual Funds , Retirement 45 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?

  1. Index funds are very easy to understand.
  2. They likely know little to nothing about the stock market.
  3. They don’t want to recommend individual stocks or mutual funds for fear of reprisals.
  4. It’s an easy answer to a difficult question because index funds require little to no research whatsoever.
  5. 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?

  1. 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).
  2. Setup an account with a full service brokerage firm.  These are more expensive, but like anything, you get what you pay for.
  3. 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.
  4. 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.
  5. 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?

  1. 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.
  2. 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.
  3. Automated investing. Almost any mutual fund has an automatic investing plan available.
  4. 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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Posted by CJ   @   1 April 2015 45 comments
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45 Comments

Comments
Jan 9, 2010
3:39 pm
#1 Mark :

Excellent points. I do not understand all of the hype behind index funds. Passive investing never allows you to outperform the general market.
.-= Mark´s last blog ..Your 2010 Investment Playbook =-.

Jan 9, 2010
4:21 pm
#2 Matt SF :

Thanks Mark. This post was met with tremendous resentment (as you can see) so index funds definitely have their proponents.

I own them and think they make a solid low cost hedge against any screw ups I might make in my own trading accounts, but I don’t think they’ll put any serious growth prospects in a portfolio unless you specifically go for the small to mid cap index funds or maybe the Russell 2000 index fund.

I think what many people don’t seem to understand is that the indices are just a barometer of the economic climate, and when nearly every stock in that index is facing a bad business climate, index funds aren’t going to provide as much protection as they think they will.

Jan 18, 2010
11:25 am
#3 Warren :

Good post – we are both black sheep. I knew the crash was coming 3 years ago when a friend of the family talked about “reading a book” on index funds, how they were putting a very high percentage of their savings into them, and how it was just going to go up and up – they had it made. I was smiling with the look of the devil’s advocate. I just said “be careful” as there was no way I could burst his bubble.

A couple months later, after attending a talk with one of the hot shot economic analysts at our firm (making their predictions for 2008) I had questions, but couldn’t raise them in the public forum for fear of being flogged on the spot and probably escorted out of the building by security and asked not to return to work the next day. So I later sent the analyst a few pointed questions and asked for his thoughts (I know he read it because I sent it return receipt) and never received a reply.

The key question I had centered around index funds, people pumping money into them and how it was providing a false sense of a strong market. In essence that it was a self-fulfilling prophecy. At the time, index fund investing was on a big upswing, Bush was advocating letting people invest a portion of their Social Security contributions (in the market), HSAs were coming (more investing in the market), 529 college savings plans were pumping money into the market, then the index funds needed to buy more furthering demand for stocks, and so on. I asked the analyst “I see this happening, and it is predicated on the index fund investor not being trigger happy, putting his money in and letting it grow. However, don’t you think that when the music stops and the index funds get hit with redemptions from Average Joe (who says he’s a long-term investor, but will dump everything if he sees he’s lost 10%) we are going to see this upward spiral work in reverse when the index funds have to sell, put downward pressure on stocks, which invites more selling, etc., etc.?” Well, I don’t remember who that hotshot analyst was, but the way things have played out makes this keyboard jockey smile knowing he was right, and there is absolutely know reason to listen to what Wall Street tells you or who recommends what – because they don’t have a crystal ball or any special information.

Feb 19, 2010
6:27 pm
#4 Jason :

If you invested 5 years ago, the S&P beat CGMFX. At best, only 20% of managed funds beat their index in any given year. Lots of work to find the 20%, and they don’t stay the same every year so you are fighting a losing battle.

Sure it’s possible, but it’s anything but a slam dunk and difficult to achieve year after year. If you can do it hats off to you!

Feb 21, 2010
1:01 pm
#5 Matt SF :

That’s true, got to give it to you there. Heebner is a home run swinging type of fund manager, and he didn’t get out of his oil bubble stocks quickly enough, and quickly thereafter, bought into the financials way before the bottom.

There are a couple fund managers with good 10 year performances, so I might post a few of them at a future date.

Apr 8, 2010
4:05 am
#6 George :

Morningstar analyzed this fund in depth a while back, due it its apparent stellar performance. They found that while the fund itself returned an annualized 18.72% over the previous 10 years, the actual average return realized by individual investors in the fund for the same period was -11.56% annualized. That’s right, *negative* eleven and a half percent.

Of course, sure, at one buy/sell point you could have made 320%. The point is that you are far, far, far more likely to lose a significant amount of what you put in, than to make anything at all. There is another place where you can find “opportunities” like this one: Las Vegas. There are a few big winners there, too. And even more who think are winning. And even more who think they *will* win.

Apr 23, 2010
10:30 am
#7 Gary :

I have been managing clients money for 25 years. Index funds will beat 90% or more of all the mutual funds, pension funds and “geniuses” of the moment over time. The secret to successful investing is minimizing mistakes. Read that line twice because it’s the only thing that will save you from yourself! The main reason why people never do well when investing is because they keep looking for something better, and the sad truth is their isn’t anything better. Just allocate among index funds and control your emotions. People don’t pay me to trade. I earn my money because I prevent people from shooting themselves in the foot.

Apr 23, 2010
10:39 am
#8 Gary :

One more thing. I’ve noticed that most posters are male. Men are the absolute worst investors. Too much testosterone I guess. Always trying to beat the market and never actually doing it. When I ask potential male clients if they’re beating the market they always say “yes”, and then when I ask them by how much they “don’t really know”. It’s really pathetic.

Apr 23, 2010
10:41 am
#9 Matt SF :

That’s a good point… much of it is ego.

Apr 23, 2010
10:48 am
#10 Gary :

It’s all ego! I manage 75 million don’t buy and sell and I’m up 2.5% since the market high using 85% index funds. Many of our male clients waste their life away reading reading reading and watching cnbc and that idiot Cramer. I guess that gives them an excuse to avoid taliking to the wife!

Sep 17, 2010
11:13 am
#11 Aldasen :

Wow, the author could hardly have made a worse fund call.

Since the author wrote this article, the market has fallen 7% while CGM Focus has fallen 41%.

Sep 17, 2010
12:00 pm
#12 Matt SF :

Absolutely, was a horrible time to get into CGMFX. However, I chose Heebner’s fund because he has a track record of outperforming the S&P 500. Since the 1998 inception (according to Yahoo Finance) of CGMFX, he’s up around 150% while the S&P 500 is up maybe 10%? Management fees probably hurt returns, but can’t ignore his track record.

Jan 18, 2011
12:29 am
#13 Mark :

I wrote a post about the same thing. Index funds are good if you know nothing about the market. If you do you can beat their returns.

Mar 7, 2012
2:12 am
#14 Steve :

Hmmm…and let’s see, after fees, that investment in 2001 made how much net? I guess this is great if you plan on starting an investment, get lucky and pick the right fund, and retire in 7 years. After all, that is what most people do. Note that this was one fund in the article.

Regression to the mean, people.

Apr 5, 2012
9:06 am
#15 jlcollinsnh :

I’m one of those Index fund believers and, from my perspective, the internet has far more posters advocating for their unique way of beating the Index. It is a very seductive path. Oh, and only #1 of your five points applies. :)

As it happens, CGMFX is the one actively managed fund I still own so your example was of particular interest.

The problem I see with your argument is that looking back it is easy to pick the right fund. But let’s look a bit more closely at that chart.

Suppose you had indeed at the end of 1997 been smart enough to pick out Ken Heebner, from all the thousands of other money mangers, as the star he was to be.

For the 1st four years you would have had to accept sub par performance. Would your belief survived that dry spell?

Speaking of dry spells, suppose you found him in 2007, maybe by noting Morningstar’s glowing endorsement (Which he certainly deserved at the time). Had you bought CGMFX in ’07 over these last 5 years you have gotten absolutely slaughtered.

As of Q1 2012, CGMFX is outperforming the indexes. Does Mr. Heebner finally have his mojo back? I don’t know. You don’t know. Mr. Heebner doesn’t know.

What I do know is if he doesn’t 10 years from now people touting how easy it is to beat the Index will have found someone else to point to.

If you choose to try to best the Index, God Bless and God Speed. You may well be smarter and more talented than I. You are most certainly likely to be better looking. I’ll look for your name along with Warren and Peter’s in the not too distant future. (Ken’s is a bit tarnished just now)

I extend the same to all those folks I’ve met in Vegas who assure me they have bested the house. I listen, gaze up at the billion dollar casinos and reflect on how many smarter, more talented and better looking people there are than me.

Now

Feb 2, 2013
7:40 am
#16 Jay :

lol,

hows your fancy fund looking now vs the S&P?

May 4, 2013
11:53 pm
#17 az :

If CGM Focus is so great, I am unable to understand (not being sarcastic, really) why it has garnered only about 10 Bil in assets at this time (in 2013)? Thank you for any light you can shed. Am I missing something?

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