Index Funds: Good, But Not Perfect

By Steven Smith | Meanderings

Mar 04

It’s only been a few weeks since the passing of John Bogle, the inventor of the index fund. In memoriam, I – along with many others – was singing the praises of the index fund for its ultra-low-cost ability to track the broad market. One writer has even given credit to the index fund for the low rate of inflation we‘ve been experiencing.

What’s Really in Your Index Fund?

But now, with the eulogies barely finished, an SEC Commissioner and a Berkeley law professor have penned an op-ed in the New York Times cautioning us to look deeper under the hood of index funds and encouraging the SEC and Congress to consider examining whether certain index providers and some index fund companies may be engaging in practices that are harmful to investors.

The bone they pick involves the way indexes are comprised by their sponsors and the potential for corruption in the process of choosing which funds are admitted into an index – or voted off the island. Being included in an index can cause the value of a company to increase substantially. And vice versa. They point to a story in the Wall Street Journal suggesting that MSCI, a large index provider, may have been unduly influenced by the Chinese government in choosing to add Chinese stocks to its Emerging Markets Index.

They want lawmakers and regulators to insure greater transparency in the formation of indexes; which have become both the actual portfolios that many investors are invested in and benchmarks for active managers.

Hegemony Fund Advisors

Even Mr. Bogle himself, in what may have been the last public act of his life, has voiced concerns about indexing getting too big and having negative affects on the market.

In the 42 years since its inception, equity index funds have grown from nothing, to now hold $4.6 trillion and owning around 17% of total US stock market value. And 81% of index assets is controlled by three companies: Vanguard, BlackRock and State Street Global.  Bogle and others expect the dominance of indexing and concentration of stock ownership in a few companies to get even stronger.

Index funds, thankfully, are among the true long term owners of stocks. But the problems of ownership concentration are not going away and will need to be addressed.

Silly Indexes

Mr. Bogle was on of the first to warn against investing in narrow individual sector and country index funds. There are thousands of different indexes and index funds in existence today. Yes, you can invest in niche indexes devoted to cyber security or obesity. As for leveraged and inverse ETF index funds, he said this is where the “fruitcakes, nut cases and lunatic fringe” hang out.

So, when investing in index funds, stick to broad based funds representing indexes that capture the returns of total US or foreign markets. Or, perhaps, portions of those markets, such as small cap or large cap.

Dimensional Funds, the Best of Both Worlds?

On a practical level – and leaving public policy aside – index funds may not be the best way for investors to capture the risk and return exposures of the market and the various other factors that are responsible for returns. As explained in this report by Dimensional Fund Advisors (full disclosure: we recommend Dimensional funds when appropriate) there are number of costs to tracking an index. First, you have to choose one for your fund. Every asset class has more than one index which purports to represent it. And they necessarily – and randomly – perform differently over different periods of time. So which one to choose?

And replication of an index comes with costs. Indexes get reconstituted periodically and require funds which are married to the index to all buy and sell the same securities at the same time. Dimensional, one of whose goals is not to exactly track the performance of an index, uses a more flexible approach. Their funds will likely be owning the same stocks and in roughly the same proportions as an index fund. But they can trade patiently and wait for the frenzy around reconstitution to subside; buying stocks at lower prices and selling stocks at higher prices than an index fund.

As explained in the report, there are other costs as well. This may not be consistent with the ultimate goal of broad diversification within an intended asset class without necessarily tracking an arbitrary index.

Babies and Bathwater

With all the noise and criticism around indexing (or any subject, for that matter) it can be easy to lose sight of the main thing. Here, it is to distinguish between expensive and most likely ineffective investment strategies involving individual security selection and less expensive, systematic, investment strategies which capture the returns and risk factors associated with groups of securities containing common characteristics. Like all things in life, none of these strategies is perfect. Some are better than others. And the enemy of good enough is dreams of perfection.

 

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