To Index or Not to Index

All thinking about investments should start with an index fund strategy.

For those who don’t know, an index fund is an investment vehicle designed to duplicate, as closely as possible, the investment performance of an index.  The first index fund, created by John Bogle of the Vanguard Group in 1975, was the Vanguard 500 Index Fund, designed to track the S&P 500 Stock Index.

An index strategy has several advantages:

It is inexpensive.  Costs to run an index fund are typically less than 0.25%, more than 1% cheaper than the typical actively-managed mutual fund.

It is tax-efficient.  Since only a few companies are added to or deleted from the index each year, you don’t have many capital gains on which to pay tax.

It is simple.  If you index your portfolio, you don’t have to worry about choosing between the thousands of actively-managed mutual funds.  You don’t have to decide when to get into or out of the market.  Just buy the index, hold it forever and get on with your life.

So what’s not to like?  Why not simply index and be done?

While the “index and leave it alone” strategy is superior to what most investors do in practice, it suffers from several intrinsic limitations.

The first problem with indexing is that very few investors “leave it alone” when the market gets hot or cold.  Most tend to buy high and sell low, with tragic results.  If you indexed in 2007, at the end of the four placid and profitable years that started in March of 2003, and then sold in late 2008 or early 2009, you would have lost most of your money in the crash, then missed a huge rebound recovery in the stock market.  Ditto if you indexed in the late 1990s and then sold out during the 2000-2003 bear market.

The second problem is structural.  Most indexes are cap-weighted, meaning they duplicate the total value of the various stocks in the index.  The most over-valued stocks (typically growth stocks) will constitute a large portion of the index value.  During a bubble, this share can be huge.  When a bubble bursts, the index investor participates fully on the downside.  From market peak in early 2000 through the bottom in late 2002, the S&P 500 Index was down more than 45%, while most of the stocks in the S&P were actually up.

Third, while an index strategy will capture the market’s returns without fuss and at low cost, those returns are likely to be very low.  As I’ve discussed in recent blog posts, we think long-term stock market returns will be in the low-to-mid single digits, roughly 4% to 7%.  Returns in this range are so low as to challenge our ability as savers and investors to achieve our accumulation and cash-flow goals.

What’s the alternative to indexing?  We believe there are sensible contrarian strategies that have the potential to deliver higher long-term returns, net of fees, than indexing.   We think those higher returns are most likely to be found in the asset-allocation space, by understanding the relative value of stocks vs. bonds, bonds vs. real estate securities, U. S. vs. foreign stocks, growth vs. value and so on.  The core of what we are trying to do, investment-wise, is to flow funds from areas of the financial markets over-valued because of investor exuberance, and toward other assets that are temporarily cheap because they have fallen out of favor.

We believe the potential benefits of a contrarian, value-based strategy are profound, but they are not continuous.  There’s the rub:  No strategy, none, will out-perform the index all the time.  Not Warren Buffett at Berkshire Hathaway, not Peter Lynch in the glory days of Magellan, not Jean-Marie Eveillard at SoGen International, not Jeremy Grantham of GMO.

If you are continuously comparing any strategy to the index, you will inevitably encounter a period when the index outperforms.  What is worse, that period of superior index performance is likely to be during a growth cycle in the market.  If you abandon a value strategy and adopt an index strategy based on better near-term performance, you are almost guaranteed to switch at the least opportune time — as large numbers of people did at the end of the tech bubble, with ruinous consequences.  Jeremy Grantham wrote a great piece about this phenomenon in the wake of the tech collapse, which can be found here.  (You’ll need to set up a user account with GMO.)

More on investment strategy in future posts.

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