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The Perils Of "Index Investing"

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
December 6, 2005

IN THIS ISSUE:

1.  Index Investing Is Big Business

2.  The Basics Of Index Investing

3.  Shortcomings Of Index Investing

4.  Are Low Fees The Key To Investment Success?

5.  Risk Management Is Crucial

Introduction

Index investing” is growing like wildfire among investors today.  Mutual fund statistics show that a growing percentage of money flowing into the market is through the many investment products that track a specific market index.  And it’s no wonder why.  The allure of a simple, low-cost investment strategy tied to market indices that have been shown to grow over long periods of time sounds irresistible.

The main problem is that Wall Street’s ad machine is only telling half of the story.  They often use historical time periods that are far longer than what most people have to invest, and they also fail to disclose how much an investor might lose in a bear market or major correction. 

I have always been wary of investments that have the ability to “fall off a cliff,” meaning that they have the potential to decrease in value rapidly.   Index investing is just such a strategy, and the losses can be substantial.  During the recent bear market of 2000 - 2002, the S&P 500 Index lost over 45% of its value, and the Nasdaq Composite fared even worse, losing over 75%!

Even with these huge market losses fresh on their minds, investors are still flocking to index investing as if there will never be another bear market or correction.  I think at least part of the reason for this is that there are so many different investment opinions and theories that investors just don’t know which way to turn.  Many choose to stay in cash rather than making the wrong decision.  They are simply paralyzed by all of the conflicting information out there.  I call it "information overload ."

Over the course of my career, I have found that most investors’ goals are very simple.  They want to put their money into investments that are: 1) reasonably safe; 2) have the potential to earn a reasonable rate of return; and 3) will not suffer large losses along the way.  While these goals are relatively simple, how you invest to achieve them is not a simple process.

However, the investment industry is always willing to create products to fill investor demands.  For those wanting a simple solution, the financial services industry has created a number of different “one-size-fits-all” investment products, with index investing being one of the most popular at the moment.

In this week’s E-Letter, I’m going to examine the recent index investing phenomenon, analyze the factors that have led to its popularity, and discuss some key disadvantages of this investment strategy that you may not hear elsewhere. 

Index Investing Is Big Business

In case you haven’t noticed, index investing is booming right now.  It seems that each week we see a new index fund or “exchange-traded fund” (ETF) announced.  All of these funds seek to provide performance that approximates the performance of a specific market index.  Index funds are also known as “passively managed” funds since there is no discretionary trading.  All market positions and the percentages they represent in the fund are dictated by the underlying index.

One of the early pioneers of index investing was John Bogle, founder and former CEO of the huge Vanguard family of mutual funds.  Vanguard produced the very first index fund in 1975, and it still exists today.  The Vanguard 500 Index Fund is not only the largest index fund, but it is also the largest mutual fund in the world with over $70 billion of assets as this is written.  Due to Bogle’s insistence on the superiority of index funds, Vanguard has grown to a dominant position in the mutual fund industry, spawning many competing index funds at other fund families.

In the mid 1990s, Rydex Funds took indexing to the next level by offering a number of different mutual funds based on a wide variety of market indices.  Not only did these funds provide for a wider array of indices, but they also allowed up to 2-to-1 leverage on some funds, and even the ability to “short” the market using inverse index funds.  Perhaps most importantly, Rydex allows investors to switch among its various index funds at will without any early redemption fees.

Rydex was soon followed by ProFunds and Potomac Funds in the generation of low-cost index funds and ETFs.  As a result, the proliferation of index funds and ETFs continues.  There are now funds and ETFs that mimic virtually every market index as well as those for specific market sectors, international market indices, and even gold and precious metals indices.

The Basics of Index Investing

The entire idea driving index investing is the premise that an investor using actively managed funds cannot do better than the market indices over long periods of time.  Actively managed funds are traditional mutual funds where the fund manager uses analytical techniques to identify stocks that will hopefully outperform the overall market.

Proponents of index investing point to various studies through the years that have shown that active management does not provide any long-term benefit over and above investing in market indices.  One of the first of these studies was presented by Burton Malkiel in his 1973 book, “ A Random Walk Down Wall Street.”  It is thought that this book was at least partially responsible for John Bogle’s decision to create the Vanguard 500 Index Fund in 1975.

Malkiel’s work was soon followed by similar articles from Charles D. Ellis in 1975, and William D. Gray III in 1983.  Perhaps the best reasoning behind index investing can be expressed using Malkiel’s own words in a 1995 “Journal of Finance” article:

“Most investors would be considerably better off by purchasing a low expense index fund than by trying to select an active fund manager who appears to possess a ‘hot hand.’”

Thus, the main tenet of index fund investing is that active mutual fund managers cannot do any better than the major market indices, so why try?  They contend that you are better off just putting your money in one or more index funds and let the market’s long-term uptrend take care of you.  But as I will point out below, it’s not always so simple or easy.

Based on available statistical analyses, these prophets of index investing seem to have a point.  For example, they cite the statistics that no actively managed mutual fund has ever outperformed “the market” over a 40-year period, and over 90% of all actively managed funds fail to outperform “the market” over a 10-year period.  I’ll discuss these findings in more detail below, but suffice it to say that such statistics make for powerful marketing materials for the index crowd.

Index investing believers also have another powerful argument, and that is in the area of fees.  Because index funds and ETFs are passively managed based on whatever the underlying market index holds, the fees on these funds are far lower than actively managed funds.  In addition, as the index fund gets larger, there is little additional challenge in managing the fund, so the fund expenses get lower as a percentage of fund assets.  The Vanguard 500 Index Fund currently has a total expense ratio of only 0.18%, as compared to about 1.5% for the average actively managed fund.

Most of all, however, I think the allure of index investing lies in the fact that it is simple to understand and implement for the average investor.

Chinks In The Index Investing Armor

Before I discuss some of the arguments against index investing, let me say that I am a big fan of both index funds and ETFs.  I feel that the ability to “buy the index” has changed the investing landscape in a number of positive ways, though I don’t always agree with proponents of buying and holding index funds.  Several of the Advisors whose programs I recommend use these index funds to facilitate their active management strategies, so I am a big fan.

That being said, I do not think a buy-and-hold investment strategy using index funds is always the best alternative for an investor.  The reason for this is within the passively managed nature of the index fund.  Index funds, by their very nature, will not exit positions and move to cash during bear markets or downward corrections.  An index fund will follow its underlying index, even if it dives right into the dirt.

Index fund proponents say that this is no problem - just diversify among a variety of index funds covering various stock and bond asset classes, and everything will be OK in the long run.  This strategy is illustrated by an investment offer I recently received from a financial Advisor.

The Advisor recommended only “index” funds allocated among a variety of selected funds based on traditional asset allocation principles.  The Advisor went on to illustrate the performance of a set of index funds over a 25-year period of time from 1979 through 2004.  The performance was excellent, especially as compared to fixed rate investments like CDs, money market accounts and fixed annuities.

The Advisor’s implication was clear: the market indices will do well over long periods of time, so all you need to do is invest in his special blend of index funds and you’ll be just fine.

Sorry, but I’m still not convinced.  Here are just a few of the fallacies of this argument, in my opinion:

1.    It assumes the next 25 years will be the same as the last 25 years. Let’s see, did a gazillion Baby Boomers retire in the last 25 years?  Were we afraid of terrorist attacks on our major financial centers prior to 2001?  Will Medicare and Social Security costs be the same percentage of government spending in the next 25 years as they were in the last 25 years?  (Hint:  “NO” is an appropriate answer to all of these questions.)
2.    The 25-year time period cited as an example doesn’t necessarily correspond to any individual investor’s actual time frame.  What if an investor’s time frame had them needing their money for retirement in December of 2002 during the bear market?  I doubt index investing would have met with much praise at that point in time.
3.    It doesn’t hurt your argument when you choose a 25-year period that just happens to include the longest bull market in history, along with a stock market bubble in the go-go 90s.  Let’s roll the clock on back a bit.  What if we chose a period of time from 1966 through 1982.  Over this 16-year span of time, the stock market went nowhere
You may not recall, but back in the 1970s and early 1980s, banks and fixed annuity salesmen were using the lousy stock market performance to persuade investors NOT to invest in the stock market.  In investment analysis, timing is everything.  The ability to reach your investment goals depends upon how the markets act in the next 5, 10, or 20 years, or whatever your time period will be.  Furthermore, there is absolutely no way to insure that the performance of any historical period of time will be duplicated in the future.
Even John Bogle, the father of index investing, has pointed out that “ each and every comparison we see is period-dependent.”  This means that the time period you choose can greatly affect the outcome of your analysis.  I have written about this before, but it is especially important in regard to index investing.
A recent article by Christpher Carosa, CTFA in the “Journal of Financial Planning” magazine illustrates this shortcoming.  Carosa analyzed the equal-weighted average annual return of all U.S. equity mutual funds over a 25-year period from January 1975 through December 1999.  Over this period of time, the average mutual fund return was 16.99%, which was less than the 17.26% average annual return of the S&P 500 Index.
However, if you expand the data through June of 2004, the mutual fund return was 13.93% versus the S&P 500 return of 13.73%.  Thus, the period of time selected for the analysis can significantly affect the outcome.
Carosa’s research went on to discuss two very important flaws that have framed the active versus passive investment debate over the years.  His article is long and very technically oriented, but its conclusions were that these two flaws knock a big hole in the argument that passive management (i.e. – index investing in this case) consistently beats active management.  Carosa’s study concluded:
“An analysis of investment return data from January 1975 through June 2004 shows active investors in U.S. equity funds performed better than the S&P 500 two-thirds of the time and by an average of 2 percent annually.” [Emphasis added, GH.]
In addition, Carosa’s research showed that investors in actively managed mutual funds actually took on less risk than the index.  A complete copy of Carosa’s research can be found in the October issue of the “Journal of Financial Planning” magazine.
4.    The discussion of various time periods brings up an interesting point.  Historical analysis does show that stocks increase in value over long periods of time.  Yet, there are many shorter periods in which stocks do poorly, or even lose money.  You often see performance data for the stock market illustrated over 25 years, 50 years and even 75 years.  Yet, few people trying to make investment decisions today have a 75-year time horizon!  Nevertheless, there are a multitude of investment articles in the financial press using this time frame to illustrate the benefits of index investing.  Even the shorter 25-year time frame may not be feasible for many of today’s investors.
Statistics tell us that we get our kids out of college and hit our high-earning years in our late 40s and 50s.  That's when we are supposed to be able to sock away lots of cash for retirement.  Yet many of today’s Baby Boomers have been busy living the American dream, not putting away much in the way of a nest egg.  They figure that these high-earning years will carry them through to retirement.
But look at the timelines.  A worker age 45 has 20 years until retirement at 65 (assuming that this artificial determination of human obsolescence continues to be the norm).  A 50-year-old has only 15 years, and at 55, you’re looking at only a decade to accumulate wealth.  Are there lots of 10-year periods during which the major market indexes did poorly?  You bet there are!
So, you have to ask yourself, what historical 10-year period will the next 10 years be like?  Don’t know?  Neither do I, and neither do economists, financial planners, mutual fund managers, or anyone else.

Do Low Fees = Good Investments?

One area where the index investing proponents have been successful is that of fees.  Many investors will reject any investment with expenses greater than those of an index fund.  They have bought into the idea that active management doesn’t pay, so they are not willing to pay higher fees for the expertise of an active manager.  They use fees as a simple way to eliminate alternatives from their investment radar screen.

Unfortunately, this simple criterion can eliminate many qualified alternatives.  After all, do you drive the least expensive car?  Why not?  Don’t all cars offer you a mode of transportation?  Do you shop for the least expensive doctor, lawyer, or dentist?  Those who do many times find out exactly why they charge fees under the going rates. 

The important thing is not always what fees are being charged, but how the investment program has performed net of all fees and expenses.   Many people will pay more for a product or service if they can see, hear, or feel added value, and investments should be no different.  The problem with money management is the ability to quantify an Advisor’s added value since it is in the form of future potential results, which no one can predict.  Thus, all we have to go on are the statistics of past performance, but even these can be manipulated, as Mr. Carosa’s research has shown us.

I mentioned above that a statistical analysis of mutual funds shows that over 90% of equity mutual funds do not beat the indices over the last 10 years, which is true.  However, you have to stop and ask why that may be true.  Over the last 10 years, we have experienced some of the best stock market performances on record.  In such hot environments, no fund manager is likely to do better than the market.

I also noted above that no mutual fund beat the overall market over a 40-year period.  This is just another example of where statistics can be accurate, but misleading.  When considering this statistic, is important to remember that superior performance is usually “manager-specific.”  Thus, it’s not surprising that no mutual fund beats the market over a 40-year period, since most mutual fund managers do not have a 40-year career at a single fund. 

Finally, there are some financial services companies that extol the virtues of low fees to “retail” investors, while at the same time offering hedge funds to their wealthy clients.  As you probably already know, hedge funds carry some of the highest fees of any investment vehicle.  Most hedge funds will charge a set management fee of 1% to 2%, plus an incentive fee, which can be as high as 20% of new profits.

So, if high fees are such a bane on the investment industry, then why are wealthy individuals flocking to hedge funds as never before?  The answer is that there are some (albeit few) money managers who are able to provide value over and above their fees in the form of consistent absolute returns.  In addition, these managers can also reduce the risks associated with being in the market, which help to lessen the probability that a major market downturn will eliminate a large chunk of equity right when the investor needs it most.

Of course, there is no guarantee that high fees lead to successful investment results, but it is true that a successful money manager will charge more than your typical index fund, since a great deal of time and talent is required to guide a successful fund strategy.  When I hear that over 90% of all fund managers don’t beat the market, I don’t think that I should give up and settle for an index fund.  Rather, I want to know who makes up that 10% that is doing better than the markets.  With over 5,000 stock and hybrid mutual funds out there, that means there are a lot of good mutual funds that bear searching out.

What About Risk Management?

As I noted above, many investors seek investments that are 1) reasonably safe; 2) have the potential to earn a reasonable rate of growth; and 3) will not suffer large losses along the way.   My biggest problem with index investing is that it can fail all three of these tests.

On the first issue of safety, you could say that index investing passes this test in one sense because there is little likelihood of losing money through embezzlement or fraud.  However, safety can mean more than protection from fraud.  As I mentioned above, there are some new index funds that allow investors to “short” the market, or participate in a fund that generates double the movement of the underlying market through 2-to-1 leverage.

While the ability to short the market and leverage positions offers a lot of flexibility, it also offers a lot of additional risk.  Unless managed by a competent professional using a disciplined strategy, I consider participation in leveraged and short funds little more than gambling.  You might win big, but you can lose just as big, and may never be able to recover your losses.

As for the second test of the potential to earn a reasonable rate of growth, index investing proponents would say that index funds pass this test with flying colors, considering the historical long-term return of the stock market.  However, as I have shown in this article, stock market returns are very period-dependent.  The shorter your investment time horizon, the better the chance that index funds will provide results below their long-term average.  In fact, there have been examples in the past where the stock market has gone virtually nowhere for 10, 15 or even 20 years.

On the final qualification that the investment program not suffer large losses along the way, index investing fails miserably.  Since there is no active management of the underlying portfolio, the investor is destined to rise and fall with the markets.  During the past bear market of 2000 – 2002, the major market indices had some tremendous drawdowns in value, with the S&P 500 losing over 45% of its value, and the Nasdaq Composite Index losing over 75%! 

My staff and I have personally talked to a number of investors who needed their money for retirement during this time, only to find that a large part of their investments’ values had vanished into thin air.  Even if I were sold on the value of index investing over the long haul, I would still not recommend it to my clients simply because of this last shortcoming.

Conclusions

I would like to say that the recent article by Christopher Carosa and this E-Letter would put a damper on the index investing mania.  Unfortunately, it’s not going to happen.  There are far too many large investment firms that have invested too much money in the development and promotion of index investing for them to ever admit that there may be shortcomings to this strategy.

In addition, investors who yearn for simplicity will continue to flock to the index investing programs because of their ease of understanding and participation.  Unfortunately, what these investors do not realize is that there is no single “best” investment alternative for all investors, or even for an investor’s entire portfolio.  While the one-size-fits-all programs appear to be very attractive, they have shortcomings that can lead to disappointment in the future.

One of the primary reasons I agreed to write this weekly E-Letter in the first place was the hope that I might be able to make a difference by countering some of the expensive marketing efforts launched by the major Wall Street firms and large mutual fund families.  In this way, I can share some of the insights I have been able to gain from my 30 years in the investment industry.

If you have been approached by someone selling index funds, I hope this article has enabled you to see through some of the hype.  If you are interested in programs that invest in the equity markets through a professional Investment Advisor who manages not only for returns, but also for the downside risk, give us a call at 800-348-3601, or click here for an online contact form.

Very best regards,

Gary D. Halbert

 

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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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