You Sure You Want To Buy That Index Fund?

Naturally the disservice done students and gullible investment professionals who have swallowed EMH has been an extraordinary service to us . . . In any sort of a contestfinancial, mental, or physicalit’s an enormous advantage to have opponents who have been taught that it’s useless to even try.Warren Buffett

If you’ve searched for any sort of investment advice within the past half-decade, you’ve heard about index funds — cheap mutual funds/ETFs that use algorithms to mirror certain broad market indexes like a basket of the 500 largest U.S. companies. Because there is no real overhead to run an index fund, they’re cheap. And because of that reason, many think Index funds are the perfect investment.

The indexing craze really started in the early 70s, when economist Burton Malkiel published A Random Walk Down Wall Street (which is still one of the most influential books on investing). Malkiel helped bring the theories of academic superstar Eugene Fama and company to a wider audience. He echoed the Efficient Market Hypothesis thesis that stock price fluctuations are random and unpredictable, and that in the long run it is folly to try to outperform the market. The old saying, ‘If you can’t beat ’em, join ‘em,’ was basically Malkiel’s advice: Instead of trying to beat the market, be content with riding it and taking advantage of its long-term upward trend.

The advice was met with some resistance from investment professionals because Malkiel was essentially questioning whether they were providing real value for their clients. But his book arrived at a critical time for the field of investing. First, the stock market was in the middle of a long slump, and skeptical investors were open to new ideas. Second, institutional investors (like mutual funds and pension funds) were responsible for a growing share of the stock market (from 34% in 1969 to 43% in 1978), and were looking for predictable performance. Finally, the new field of finance economics, with bases at schools like the University of Chicago and MIT, was finally being taken seriously on Wall Street.

Once again, Index funds are passively managed mutual funds that — in contrast to actively managed funds that try to beat the market — use a set formula to mirror the market, or a particular segment or index of the market (sometimes called a benchmark). For example, the first index fund, still one of the most popular, is set up to mirror the S&P 500 (the 500 biggest companies in the U.S., as measured by total capitalization). They’re growing rapidly, In 2016, active funds experienced a net “outflow” for the first time since 2008 — in other words, more money was withdrawn than invested. Active funds lost $207 billion while index funds gained about twice as much. And in the last fifteen years, passive funds’ share of the equity mutual fund market has more than doubled: from less than 10% to over 20%.

The popularity behind indexing has caused the onset of a (potentially) major macro problem.

The focus on indexing has swayed many investors from focusing on fundamentals to management cost. Not the cost of a basket of stocks relative to its aggregate future earnings (aka valuation), but actual cost of holding a specific fund.

The result is that capital is indirectly transferring into stocks like Apple and Amazon simply because they are big and make up a large portion of the index. The demand for (cap weighted) indexing = demand for these large companies and prices rise, making them bigger and expensive, which can change them from being a good investment to a poor one. Take the five largest stocks in the S&P 500:

Apple: 23%
Alphabet: 9%
Microsoft: 6%
Amazon: 20%
Facebook: 25%

The five stocks above represent 42% of the Nasdaq and 13% of the S&P 500. That means every time you buy a NASDAQ 100 index fund, 42% of your investment allocates into only five stocks, leaving 58% for the remaining 95 in the index.

This has and will continue to affect the prospective returns of these companies, which will alter its risk-profile: Meaning a once safe stock may very well become risky.

In my book, The Millennial Advantage, I discuss the fundamentals of value investing and argue that it’s wise for investors to seek undervalued companies, which tend to be those that are ignored. Smaller and “less sexy” companies are usually the ones that fit this bill.

The general belief these days is that access to information is so easy and conflict free that it’s impossible to find profitable opportunities (hidden gems) within the market, thus it makes most sense to minimize expenses and track the index.

I argue that the indexing craze establishes HUGE opportunities in smaller companies that aren’t included in today’s popular indexes. While access to information is obviously easy, certain impediments (which I discuss in my book) prevent institutions and other investors from doing the due diligence necessary, and this creates opportunity to profit. One of these impediments is “benchmarking,” which incentivizes managers to mimic indexes to keep up with general returns (so investors don’t withdraw funds).  This is the major issue with large company stocks today.  Because of indexing, they’re expensive, which in turn, makes them a less attractive investment.  On the other hand, smaller companies, being ignored, trade cheaper and thus can serve as a space to find well run companies.  As Warren Buffet says, investors should search for “quality companies at quality prices.”

Long live Small Caps!