Are Index Funds Fatally Flawed?

“No one pretends that democracy is perfect or all-wise,” Winston Churchill famously said in a 1947 speech. “Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried.”

I recalled this bit of wisdom recently when two readers sent me links to articles that question the safety of index funds. Both identify genuine flaws in traditional cap-weighted index funds. But the problem—as always—is that the alternatives turn out to be worse. In this post, I’ll look at some of the arguments levelled at equity index funds. Next time, we’ll turn the focus to bond indexes.

Earlier this month, the venerable New York Times ran an article called The Ease of Index Funds Comes With Risk. The piece acknowledges the many benefits of index ETFs but then warns that “their simplicity harbors some simmering problems, which have grown more troubling in the course of the bull market in stocks.” It goes to say that “cracks in the edifice of passive investing are beginning to show.”

Experts in the article are concerned that the mere inclusion of a stock in a major index—particularly the S&P 500 of large-cap stocks and the Russell 2000, which tracks small caps—can distort its price. Companies in these popular indexes are systematically overvalued, they say, presumably because index-tracking funds are buying them in enormous volume. “The whole market is overvalued,” one fund manager says. “Index stocks are more overvalued.”

A related problem, the articles goes on to argue, is that overvalued stocks will fall harder during a correction. One professor “notes that in the October 1987 market crash, stocks that were members of the big indexes dropped 7 percent more than non-index stocks” and adds ominously, “I won’t be surprised if we see more of this sort of thing.”

You got a better idea?

Let’s acknowledge that the flaws in traditional index funds are real. Cap-weighted indexes, by definition, give a proportionally greater share to companies with high valuations. So it is absolutely true that overvalued companies will punch above their weight, while undervalued companies will exert less influence. And that’s not ideal. The problem is, who determines what is overvalued?

The premise behind indexing is not that cap-weighted indexes perfectly reflect every stock’s intrinsic value. The point is that it is extraordinarily difficult to identify which companies are overvalued or undervalued, and it is costly and tax-inefficient to put that research into practice. It’s not as easy as simply looking at a ratio like price-to-book, or price-to-earnings, as some of the article’s sources seem to imply. If it were that simple, then active mutual funds and individual stock pickers would be far more successful than they are.

As for the argument that stocks in the major indexes can be expected to suffer more in a downturn, that might be true as well. If index fund investors sell in a panic, they will be dumping all of the companies in the index en masse, with no regard to their fundamentals. But again, if you’re going to make that argument, you need to present an alternative.

One of the experts in the article has a suggestion: he argues for “a shift by investors to non-index stocks.” I wonder how an investor would put that strategy into practice. How exactly would you build a portfolio of US stocks that shied away from those in the S&P 500 (which includes the largest and most liquid companies in the world) or the Russell 2000? Would you be handpicking mid-cap and micro-cap stocks you deem to be undervalued? Is that really a strategy you want to adopt? Do you honestly believe that is less risky than an index fund?

It’s hard to understand the griping in the article. Active fund managers should be licking their chops if they think index funds are distorting stock prices, because that would present them with opportunities to exploit the chumps like you and me who are buying these things. And yet over the five years ending June 30, some 78% of all US equity funds lagged their benchmarks, according to the latest SPIVA report card. That number jumped past 86% for small-cap core and small-cap value funds.

Weighing your options

If you still feel swayed by arguments like those in the Times, there are some simple fixes that don’t involve picking stocks or rushing into the arms of fund managers who think they’re smarter than the market. One is even mentioned in the article: just use a fund that tracks a total-market index. Unlike the S&P 500 and the Russell 2000, these indexes don’t wield any influence by adding or deleting companies: they simply hold all companies of any meaningful size. The Vanguard US Total Market (VUN), with more than 3,800 stocks, does the trick nicely.

Another option is to look for an index that isn’t cap-weighted. The well-known problems with traditional indexes were the reason alternatives like fundamental indexing were created more than a decade ago. (These indexes weight companies based on factors such as book value, total sales, cash flow and dividends rather than market capitalization.) Just be aware that you’ll pay a premium: the iShares US Fundamental (CLU.C), for example, carries an MER of 0.71%, which is 10 times cost of the Vanguard S&P 500 (VFV).

Or you could simply accept that cap-weighted index funds are, like democracy, not perfect or all-wise. But they’re cheap, tax-efficient, and almost always perform as advertised. That makes them the worst investment strategy except all those other forms that have been tried.

 

28 Responses to Are Index Funds Fatally Flawed?

  1. Big Cajun Man (AW) October 30, 2015 at 9:57 am #

    I think if everyone, or even a significant number of folks went to Index Funds (that were genuinely Index Funds, not just by name) it would be interesting to see if the market could be “played” or not, however, as long as there are folks with “fool-proof systems to make double digit growth every year, and beat the markets” Index Funds will make the most sense to the average investor.

  2. Phil October 30, 2015 at 10:43 am #

    Interesting as this goes with the “active share” strategy employed by some fund managers both etf and mutual fund. The problem I see is that the term index fund is so distorted now, people’s interpretations of what is going on in these investments are going to be different and going to affect their outcomes when they don’t perform as expected

  3. Bill G October 30, 2015 at 12:41 pm #

    This seems like fear, uncertainty and doubt being spread by the active managed crowd. The quote “cracks in the edifice of passive investing are beginning to show” implies there is some magic sauce to ETFs that has been providing unnatural returns. If you compare a pure equity index fund to a balanced active fund the risk profile is different and is an apples to oranges comparison. If you compare a balanced ETF portfolio to a balanced active fund, how is the risk different? Where are the cracks?

  4. Jim October 30, 2015 at 1:12 pm #

    I don’t think using a total-market index fund, like VUN, fixes the problem, unless EVERYONE used it, and only it, to invest.

    A fund like VUN may not be contributing to the problem of a stock being over-valued because it (the stock) is part of an index, but it is still a victim of the over-valuation problem.

    VUN is still roughly made up of 80% stocks that are included in the S&P 500 index. So the other index funds that follow the S&P 500 index (and the millions of people investing in them) are still creating the over-valuation problem, and VUN is still a victim of that problem.

    Every investor in the world would have to invest in the total-market index fund to fix the problem.

    It is true that “these indexes don’t wield any influence by adding or deleting companies”, but they still have the over-valuation problem caused by all the other index funds.

  5. Willy October 30, 2015 at 1:32 pm #

    Really great article, and I couldn’t possibly agree more. The article cites a couple data points and then seems to draw the wrong conclusions.

    The article is suggesting stocks more included in large indices are at higher valuation levels than those less included. But comparing VOO (S&P500, 500 stocks) vs. VTI (Total Market, 3800 stocks) from Vanguard’s website shows that their trailing 5yr returns are almost EXACTLY the same (within 0.02% annually), while their “intrinsic value” measures such as P/B, P/E, etc are all just about the same too. Even if you compare VOO to VXF, you see that the returns are just about the same (only 0.3% different annually), and the P/B and P/E are within 10% of each other.

    So you might argue that the whole market is overvalued. And it could be, I don’t know. But the argument that there are dislocations within the market attributable to stocks more commonly included in indices seems wholly wrong.

  6. Joe October 30, 2015 at 1:38 pm #

    One area that I am having a little trouble finding the data to support your statement “That number jumped past 86% for small-cap core and small-cap value funds.”
    While I am a big supporter of the index funds for large caps, I am very hesitant to support the small caps indexes. This is especially true for Canadian and International small caps.

    At one time I had the combo of XCS / VBR but after some research I found a well mangaged small cap fund (like MAW150) performed much better. I did take into condsideration using SCZ etf but still found a well managed fund the better solution.

    Any thoughts?

  7. Adam October 30, 2015 at 1:44 pm #

    I wonder if there are hedge funds that try to buy up stocks on the cusp of joining a major index in large enough amounts to raise their prices and get them into the index, meanwhile shorting the stocks that they want to get pushed out. Then rinse and repeat. Seems like that might work depending on how often the index is reconstituted, and probably lots of other factors.

  8. Jake October 30, 2015 at 1:46 pm #

    @Joe

    Do you know what the performance for the next 5,10,15 years of MAW150 will be compared to the index? Past performance doesn’t mean the performance will continue. At least with passive index funds you know you will get the return of the index minus the fund fees.

  9. Doug Morrow October 30, 2015 at 1:55 pm #

    Thanks for this Dan. I’m not swayed by this NYT article and I will continue my boring approach of using unimaginative low cost mkt-cap weighted ETFs. One question, wouldn’t the Russell 2000 be considered a total market index? If it’s not, it must be close…

  10. Tristan October 30, 2015 at 2:18 pm #

    I like to think of it this way. The markets are extremely efficient most of the time, but there are times, like during bubbles and panics, when the markets are not so efficient and can become over and undervalued. During these times cap weighted indexes can be affected as described in the NY Times article. But over the long term, it doesn’t matter, because most of the time the markets are very efficient and, besides, as CCP points out, the alternatives are worse.

    As for fundamental indexes, there are times they outperform broad market indexes, but that’s because of higher loadings of small and value factors. I think these factors can be more efficiently accessed by investing in cap weighted small and value index funds.

    As Bill G points out, NY Times article is just another attempt by the active mangement industry to scare people back into their arms. Don’t believe a word of it!

  11. Canadian Couch Potato October 30, 2015 at 2:28 pm #

    @Jim: You’re right, of course, that if the whole market is overvalued then VUN doesn’t help you. The problem, as always, comes down to what you do if you think the whole US market is overvalued. Don’t invest in US stocks? Pick a handful of undervalued exceptions? Those are lousy alternatives. If you really couldn’t shake that view I suppose the best solution would be to use a fundamental index.

    @Joe: That number is right out of the SPIVA report card I linked to (see page 4 of the PDF). I think it’s reasonable to expect that an active manager has more potential to outperform in the small cap space, where markets are likely to be less efficient. But I think you will find that many small cap funds are quite a bit riskier than index funds because of their concentration in relatively few holdings. (As a side note: small-cap index funds in Canada have their own problem: namely an enormous concentration in materials and energy sector.)

    @Doug: The Russell 3000 is pretty close to a total market index. That is then subdivided into the Russell 1000 (large caps) and the Russell 2000 (small caps).

  12. Adam October 30, 2015 at 6:55 pm #

    What about equal weighted index ETFs?

    RSP, Guggenheim S&P 500 Equal Weight, over the last 10 years has beaten SPY. Total return of RSP was 130.7% to SPY’s 112.3% over that period.

  13. Tyler October 31, 2015 at 10:07 am #

    If in a crash, a stock in the S&P500 drops an extra 7%, then it must have gained an extra 7% in the preceding bull market. So over the long term, the net gain/penalty is zero, no?

  14. jamie November 1, 2015 at 9:47 am #

    Hello Dan,
    Through years of following your great blog and after reading numerous books I am a committed indexer. But I do hedge my bets between cap weighing and fundamental approaches–using Vanguard and Power Shares among others. Your own in house approach at PWL is to use Dimensional Funds trying to implement the Fama/French research results. Tristan’s comment above that cap weighing with a value and small cap tilt is more efficient than Fundamental indexing is very interesting. Is it time to have a retrospective on the issues around cap weighing and various alternatives as well as comparing results. Or do you feel this has already been dealt with well enough in your previous blogs?
    Ps. I have never heard any critics address the claims made by Fundamental Indexers that the asserted value and small cap tilt of the index is not the key element as claimed by its critics. This emphasis on tilt misses the automatic process inherent in Fundamental indexing of re balancing –this re balancing away from market exuberance, they claim, is the most important factor of the approach and it is the re-balancing which principally accounts for its claimed out-performance . Any thoughts on this potential debate?

  15. Canadian Couch Potato November 1, 2015 at 10:25 am #

    @Jamie: Thanks for the comment. I feel like I’ve already written a lot about alternative indexes, and I also believe my commentary hasn’t been what most people want to hear. I think it’s too easy to get caught up in comparing the alternatives to cap-weighting, much of which involves backtesting hypothetical strategies. Everything always comes out trouncing cap-weighting. And yet there are so few investors who have actually obtained those returns in the real world.
    http://canadiancouchpotato.com/2013/07/15/does-smart-beta-really-beat-cap-weighting/
    http://canadiancouchpotato.com/2013/07/18/why-your-problem-is-not-your-funds/

    The more experience I get, the more I believe it is often a huge distraction, because it becomes an endless pursuit of something better. I always come back to the same point: there are no investors who failed to meet their financial goals because they captured only market returns and no more. There are countless investors who failed by blowing up their portfolios trying to outperform. Even in our practice we are moving increasingly toward plain-vanilla ETF portfolios for new clients to keep things cheaper and simpler.

  16. oldie November 2, 2015 at 2:41 pm #

    So the “experts” (??) say “mere inclusion of a stock in a major index—particularly the S&P 500 of large-cap stocks and the Russell 2000, which tracks small caps—can distort its price.” Really? The subsequent fleshing out of this view turns out to be a circular argument that makes no sense. Again.

    As the spud guru says, boringly yet again, (and yet we sometimes still don’t fully get it!), “there are no investors who failed to meet their financial goals because they captured only market returns and no more.” End of discussion. We should paint these word on our walls and keep on reading them aloud over and over to ourselves. Everything else is noise.

  17. Garth November 2, 2015 at 6:12 pm #

    Someone once said that Vanguard’s genius was in their definition of failure…which is failing to achieve market returns less a small amount for expenses. Not many active funds or strategies can consistently beat them when using this definition.

  18. Peter November 3, 2015 at 12:36 am #

    Interesting article. It shows the risk with index funds or ETFs and how certain indexes are weighed heavily towards certain stocks and less to others. So if a certain stock gets over valued then the Index is not a good indicator of what is happening.

    I think the reason for index investing is to capture the ups, downs and the flat days. It will average itself out but there are 500 companies in the SP 500, there is no way you want an equal weigh to the small caps.

    index investing is fine with, risks and all.

  19. Shaun November 5, 2015 at 3:53 pm #

    @CCP

    Nice post again Dan. You suggested that if you are going to make an argument then an alternative must be sugested.

    I went to the SPVIA website to read up on the study you referenced. On that site I found the following article regarding mid-cap indexing:

    http://ca.spindices.com/documents/education/practice-essentials-mid-cap-a-sweet-spot-for-performance.pdf?force_download=true

    They show that that over the last 20 years, the S&P 400 mid-cap index has outperformed it’s large-cap and small-cap counterparts pretty consistently. They argue that mid cap stocks may be in the sweet spot of a corporation’s life cycle “in which firms have successfully navigated the challenges inherent to small companies, such as raising initial capital and managing early growth but are still quite dynamic and not so large that rapid growth is unattainable.”

    This article got me thinking that the mid cap segment may be able to minimize the overvaluation issue of the broader index that you talked about. You would not have to invest in tiny micro-cap stocks, but if valuations get out of control on stocks in your index and the stock rises too quickly it would get pushed out of the top of the index and end up in the S&P 500.

    I just read this today so haven’t had much time to digest it, but it seems like an interesting concept.

    Any thoughts?

  20. Canadian Couch Potato November 5, 2015 at 9:49 pm #

    @Shaun: You can always find a segment of the market that outperformed over a given period. It’s hard to know whether the result is anything other than randomness. The “sweet spot” explanation makes a good story, but I’m not sure there is any data behind it. I would want to know whether this mid-cap outperformance has been observed in other countries, and if not, why not? Even then, I would still stick to a broad-market index and keep it simple.

  21. jamie November 5, 2015 at 10:01 pm #

    thanks again for your tireless and patient effort–certainly not thankless! and I grin when I re-read your above response to me: ” I also believe my commentary hasn’t been what most people want to hear.”

  22. Jesse November 8, 2015 at 9:26 am #

    Who wants to start a index fund consisting solely of non indexed stocks with me? Just think of all the fun names we could give it!

  23. Brian G November 10, 2015 at 1:42 am #

    Dan, you asked “You got a better idea?”

    Yes, I do… the “low-volatility anomaly”. People have been studying this since the early 1970’s and it’s still not fully understood… but it seems to keep working across time and markets.

    Then compare the performance of ZLB vs. ZCN for instance. It definitely seems to hold up during bad times. Disclosure… I hold ZLB (and ZLU and XMI) and I’ve been happy with them. I’ll revert to broad indexes if they underperform vs. their index over a multi-year period, but so far so good.

  24. Hari Seldon January 31, 2016 at 5:47 pm #

    The premise is that a market cap index overweights “expensive” stocks.

    Given that it may be difficult to differentiate between expensive and cheap, might it not matter?

    If the expensive stocks were all the small companies and the cheap stocks were large companies then a market cap index will have more assets in cheap assets than expensive stocks.

    This argument is always based around the idea that the big companies are expensive and and the small ones are cheap, the truth is we don’t know.

    With hindsight we see the overvaluation of Japanese equities in the late 80’s as obvious and the tech stocks in the late 90’s as obvious but clearly not everyone thought so.

    In early March 2009 there were not many seeing the equity market as a screaming buy me, buy me, I’m cheap!

    I’m not arguing that index funds are the best solution but they are at least satisfactory and less unsatisfactory than most of the alternatives.

  25. Canadian Couch Potato January 31, 2016 at 9:12 pm #

    @Hari: “This argument is always based around the idea that the big companies are expensive and and the small ones are cheap.” Not really. The criticism is that if a company is overvalued, then by definition its market cap is higher than it “should” be based on its intrinsic. It’s not a question of large caps versus small caps: a small cap stock that represents 0.05% of the index can still be overvalued, and a large cap stock that represents 5% of the index could be undervalued. But as you say, there is no way of reliably identifying overvalued and undervalued stocks and profiting from that mispricing. That is what value investing is all about, and it’s possible, but extremely difficult to do consistently.

  26. Todd Child March 18, 2016 at 8:48 am #

    I really enjoyed this article it really made me think about how I invest and I believe that your conclusion of just keeping a boring approach is correct. It is when we as investors try to complicate things that we end up losing.

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