click here to return to the Calico Cat homepage

Index Funds - The Good and the Bad

At least index funds don’t underperform the market

It has been known for decades that the majority of managed mutual funds underperform the S&P 500 index. Thus was the concept of the index fund fund developed. Instead of trying to outperform the S&P 500, a task that few fund managers seem able to do, why not just settle for equaling the performance of the S&P 500, thus guaranteeing that the investor in the index fund will do as well as the market?

When I first read about index funds (believe it or not, in the The Motley Fool Investment Guide), I thought they sounded like a great idea. I wanted to run out and buy the Vanguard Index Trust 500 Fund right away (except that I couldn’t because I didn’t have any money to invest).

So what’s the downside of index funds, when they outperform the typical managed fund, but with less risk?

Index funds still have risk

Let’s not ignore the fact that index funds still have quite a bit of risk. Unfortunate investors who bought index funds that tracked the NASDAQ saw the value of their investment decline 78% from March 2000 to October 2002. That’s almost like being wiped out, and that’s from a supposedly “safe” index fund. Even the safer S&P 500 index saw a 51% decline during the same time period.

Why settle for merely matching the index?

If S&P 500 index fund investors match the S&P 500, and managed mutual fund investors underperform the S&P 500, that means that the rest of the investors are beating the S&P 500 (assuming that not all of the managed fund underperformance is due to management fees). I would rather be with the investors who are beating the S&P 500. You can join that group by buying stocks directly instead of going through a mutual fund.

Index funds exhibit a bias towards overpriced stocks

The way I see it, because the S&P 500 is a marketcap weighted index, and it only includes the biggest market capitalization stocks, this means that overvalued stocks are overrepresented in the S&P 500 as well as all other marketcap weighted indexes. Buying stocks based on throwing darts at the Wall Street Journal would probably outperform the index, because the dartboard approach wouldn’t be biased towards overpriced stocks. The bias towards overpriced stocks probably explains why the research shows that smallcap stocks outperform largecap stocks.

Index funds endanger the stability of the markets

Maybe the typical individual investor isn’t concerned about destabilizing the markets based on his actions, but it’s something that I worry about. What would happen if everybody decided that they only wanted to invest in index funds because this was the safest way to invest? The result would be very bad, because there would be nothing determining the prices of stocks within the index. Perhaps one person would sell a few shares of IBM, and the stock price would nosedive because there was no market on the other side. Perhaps the values of stocks in the index would become completely divorced from the actual values of the underlying businesses? One could argue that this already happened to NASDAQ stocks during the bubble—therefore the situation can only get worse as more people do their investing through index funds.

It becomes apparent that index funds only work when a minority of investors are using them as their primary investment vehicle. I don’t think we could have stable markets if the majority of money were invested through index funds. Maybe this would be self regulating, because what might happen is that the increasing price volatility would increase the transaction costs of index funds and result in them underperforming the market, while managed funds would start outperforming the index funds because the fund managers wouldn’t be locked into mindlessly chasing in the index. And such an outcome would encourage investors to take money out of the index funds and put them into the managed funds.

The rising popularity of index funds is something that the market regulators at the SEC and the exchanges need to be keeping an eye out for. There may come a time when restrictions will have to be imposed to prevent them from becoming any bigger.

posted December 3, 2003