Disclaimer: Investing is kinda like religion in that each kind attracts its own kind of followers. If you believe in index investing, like e.g. the bogleheads, the following post will disagree with your beliefs/dogma. Keep in mind that when I discuss index investing, I’m referring to broad market indexes. While anyone can make up their own personal index of any arbitrary basket of stocks, I consider it somewhat disingenuous for a mutual fund company to call something an index fund if it’s not a popularly tracked index but merely a passive fund of e.g. North American energy stocks or Asian Small Caps. Investing in such funds is more like sector investing/rotation where the popular asset allocation portfolio model is simply yet another mechanical trading routine that intends to sell sectors that are overvalued and buy those that are undervalued under some mean reversion hypothesis.

Index investing is being touted as a kind of silver bullet. You can’t go wrong with indexes, they say. Indexes have historically produced superior results. ETFs beget a new era of investing. Here’s how to turn $1000 into $1,000,000 through the magic of compound interest. It works because it can be imagined. You guys are going to get burned, I say.

Note: I originally posted this article on July 10th in 2008 when the S&P 500 closed at 1252. I hate to say that I love to say “I told you so” 😉

Index investing is basically equivalent to a buy and hold strategy with very low turnover of a few large growth companies. This is not a bad idea per se and historically it has worked well, especially in a growing economy. Now, can we presume it will keep growing at historic rates?

The reason that it’s hard to beat an average is that any investment theory is basically mean reverting. It works and then it stops working as other investors pick it up, diminish returns which takes them down to average. In other words the arbitrage situation between better ideas and average ideas generally only last so long as the average investors pile into the better ideas.

There are a few things that show a consistent edge (permanent good ideas) over large cap indexes. Small caps with large insider holdings and stocks with low price to book values. Why? Because institutions won’t or can’t touch these either due to size or risk avoidance. If you want to leave the herd as an individual investor, that is where you should be. That and a few select beaten down blue chips (there are more of those around these days).

In other regards, the reason diversification works is that institutions pursue a variety of goals. Some go for income, some go for appreciation, etc. However, if a large segment of the market just started buying the same basket of stocks, they would no longer diversify their risk. Diversification does not come from owning multiple stocks. It comes from having multiple other players with DIFFERENT goals to share the risk with. If a large segment of the population just buy index funds they only share that risk with each other; they go up together and they go down together. That is the biggest risk of index investing (read more here).

How good is index investing on a consistent basis. Let’s look at the numbers which I lifted from a book by Mauboussin.

Year Funds beating the S&P500
1991 47.7%
1992 50.9%
1993 72.0%
1994 24.0%
1995 12.6%
1996 20.7%
1997 7.9%
1998 26.1%
1999 51.4%
2000 62.2%
2001 49.7%
2002 58.7%
2003 56.7%
2004 54.9%
2005 67.1%

I note that funds have done pretty well, on average, particularly lately when the market has been in a trading range rather than the trending of the 1990s. In addition, the fund track record if we just pick a random fund every year is killed mainly by two horrible years, namely 1995 and 1997 (presumably most of the funds did not own something that did spectacularly well in the index). In other words, I don’t think funds are as bad as they are made out to be. In fact it may be possible to pick funds based on how they reflect fashionable trends in investing e.g. low P/B, high P/S, low PEG, etc. and the no-load FundX that Millionaire Mommy Next Door uses, basically uses a technical analysis of funds(!) to find these trends. It has a very good track record (but also high fees).

For the frugal people out there, it is possible to make your own index fund. Most index funds are dominated by about 10-20 holdings, so while the S&P500 includes 500 companies, practically all of its movement is governed by the largest 10+ companies. Thus you can create a no-fee more-control portfolio that tracks the index by simply getting a free-trade broker account and buying the 10 largest stocks of your favorite index in proportion to market cap(*). For example, if company A is $300 billion, B is $200 billion and C is $100 billion, and you have $10,000, you buy $5,000 worth of A, $3,333 worth of B, and $1,667 worth of C. It’s up to you to decide whether this inconvenience is worth the fee you’re paying to use the fund. Naturally this depends a lot on whether you have $10,000 or $1,000,000 and the number of years you plan to hold.

(*) Market cap = share price * number of outstanding shares. You can find the market cap listed on yahoo’s or google’s finance pages for the individual stock. I usually search for e.g. “GE quote” to get it as the first result for General Electric’s data. Incidentally, the SP500 is weighed according to market cap, while DJIA is weighed according to share price(!!). This means that the stocks with the highest share price dominate the DJIA. If Berkshire was part of DJIA it would completely rule that index.

Originally posted 2008-07-10 07:05:27.