Why Index Funds Are An Inefficient Way To Invest

    Index funds are by far one of the most important financial creations of the 20th century. Jack Bogle is someone I admire deeply. His legacy is unmatched among financial professionals. His life’s work allowed millions of people to invest in stocks in an almost riskless way. It helped many folks in retiring. The truth is indexing is probably the best and safest option for most investors out there. It allows them to keep a strategy and diversify with minimal effort. Today index funds come in many shapes and forms, and the single most used investment vehicle for investors looking to get exposure to the markets.

    With all these advantages in mind, I tend to advocate that index funds are an inefficient investment vehicle. This is especially true for investors with a higher return appetite. Some investors are willing to put in the time into researching and learning about investments.

    The Food Analogy

    Source: Healthsite

    Let’s put it this way. You are having a meal, so you go to the supermarket and look for some ingredients. Index funds would be the equivalent of a buffet kind of package that includes a variety of different meals all packed into one. From rotten food to some high quality meat, fish or even vegetables. But the reality is that a few good bites of something wonderful won’t make up for the rotten pieces that also come in this already prepared meal. If you are a highly demanding food critic, you wouldn’t settle for an average meal. In contrast, value stock pickers are essentially walking through the supermarket aisles looking for quality ingredients at a discount. The idea is that by buying a bundle of undervalued securities one cannot lose money.

    The Choice

    It is understandable that some individual investors or even sometimes hedge funds, use ETFs and index funds to get a certain specific exposure. As the work and time necessary to research every company individually would take a lot of time. This in turn is actually the key to outperformance. Analyzing stocks individually might take time, but allows you to find opportunities across countries and sectors.

    Downsides

    Source: Majlaw

    • Fees

    One of the biggest downsides with funds are the fees that are charged. Funds inevitably incur in expense fees. These expenses are usually supported by investors, who sometimes are charged an upfront fee. Adding to that an ongoing expense fee is added on top, and charged yearly so that the fund can pay for expenses. This one of the biggest disadvantages of funds in general and index funds specifically. Don’t get me wrong, when you buy individual stocks you also pay fees. But they are not charged yearly. In the worst case scenario depending on your broker, you pay a fixed fee to buy and sell a specific security.

    According to Barron’s. The average index fund expense ratio is around 0.09%. Despite this fact there are billions invested in index mutual funds that charge over 1% in yearly fees. Fidelity was one of the first to offer zero minimum investment and zero expense ratio mutual funds. Although they are not widely used, these funds actually tackle the problem of systematically incurring in yearly fees.

    • Keep Track of Holdings

    Although it doesn’t apply to index funds. For mutual fund investors, it would be advisable to always keep track of the fund’s holdings. In essence the same amount of time and energy for individual stock picking would be necessary to carefully keep track of all of the holdings the fund adds and dismisses. Well if you are willing to put in the time to keep track of the fund’s holdings, why not just choose individual stocks outright?

    • Buying Companies You Wouldn’t Normally Invest In

    Another consequence of mutual and index funds. Is the fact that it is impossible to satisfy all investors. In essence as an investor in mutual and index funds, you have to compromise. Meaning that despite not agreeing with some of the fund’s holdings. You have no other option but to accept it. Investors in funds, end up owning pieces of businesses they wouldn’t normally invest in if they were to pick their own stocks.

    Source: Mac.Else

    • Index Fund Bubble

    Given the fact that most individual investors use funds as their primary investment vehicle. The ownership of most companies around the world is now dominated by Asset Management companies. This passive investment strategy is not always the best option. As asset management companies tend to not take a big stand in business matters, because essentially they represent a multitude of investors. This in turn allows management and boards of companies to operate without many constraints. Since the majority shareholders are represented by Asset Management companies. They usually take a passive stand on many of the key issues going on inside the business.

    Before the boom of passive investing. Active investors would dictate market prices, and passive investors would go along for the ride. Today the scenario has completely changed. Active investors have moved from a major influence to having relatively meaningless impact across markets.

    Michael Burry, who correctly predicted the housing bubble in 2008. Since 2019 he has repeatedly warned against what he describes as an Index fund bubble. In essence his theory may be right, and it might take a while until it actually unfolds. Perhaps when all the boomers retire, we will start to see the bubble collapsing. 

    Source: Business Insider

    This is because boomers own most of the wealth, roughly over 50% of total US wealth. When all of them retire and convert their investments into cash and more secure investment vehicles like bonds. We could finally see funds pressured to sell securities, as their assets under management shrink.

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    Featured image source: Clark

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