Is it time to talk about the defects of index funds now? That’s the question being asked by Hunter Lewis in Barron’s. He writes:
Index funds have had a spectacular run. They collected $8.5 trillion in retail investment dollars by the end of the first quarter of this year, according to Morningstar, more than all active strategies together. Along the way, they became the dominant investment idea.
Yet the stock market’s recent dip into bear-market territory raises new questions for these popular funds. Will indexing recover and go on to scale new heights? Or has the time come to consider its defects as well as its virtues?
The virtues are easily understood. It is a simple strategy to adopt, and usually comes with low fees. Both legendary Yale University investment head David Swensen and Berkshire Hathaway’s Warren Buffett endorsed index funds for these reasons.
“You’re guaranteed to be in the top quartile if you use indexing” over 10 to 30 years, celebrated investor Charles Ellis argued last year. “You are guaranteed to be a winner.”
Could Swensen, Buffett, and Ellis all be wrong? Yes. Especially Ellis. Why?
In theory, index funds are highly diversified. In practice, they are capitalization weighted, which means new money flows into the most popular stocks of the moment. The combination of index fund popularity together with index construction favoring the most popular stocks means that more money has flowed into fewer and fewer stocks.
The purveyors of indexes, being human, tend to make the concentration in a few expensive stocks even worse. The committee charged with overseeing the S&P 500 has changed the constituents often, and in the process tended to add stocks with price/earnings ratios more than twice that of those deleted.
Capitalization-weighted equity indexing is also “momentum” investing, in that more new money flows into what has gone up and less into what has gone down. There is an irony here. The idea of indexing is supposed to reflect “efficient markets,” where prices reflect all available information. A momentum approach isn’t supposed to work within such markets. Academic supporters of some version of market efficiency treat successful momentum investors either as an unexplained anomaly or as an example of luck.
There are other seeming contradictions embedded within index fund construction. In addition to ignoring the unarguable principle that price paid represents a key determinant of long-term return, indexing ignores much else besides.
Read more here.