Index funds – ETFs or mutual funds that strive to track the performance of a securities index – are incredibly popular right now. And why not? They combine some of the best aspects of simplicity and diversification into a single, easy to trade investment vehicle. Not surprisingly, index funds are ubiquitous at the moment. You can find them in your IRA, 401-k and even in sophisticated hedge funds.
But the big reason investors love index funds is because of their low costs compared to actively managed mutual funds. Many large, passively-managed index funds have expense ratios of only 0.05% to 0.20% annually. This translates into $5 to $20 in fees per annum for every $10,000 invested. These costs are far, far lower than actively managed equity mutual funds that typically have expense ratios between 0.60% and 1.00% every year.
Index funds are the modern no-muss, no-fuss way to invest for people who are overworked and don’t have the time or inclination to learn the intricacies of securities markets. These incredibly flexible instruments can emulate the makeup and performance of almost any index in existence – anything from the pedestrian S&P 500 Index to the exotic FTSE Japan 50% Hedged to USD Index. Index funds can also track fixed income or bond indices as well, like the Bloomberg Barclays US Aggregate Bond Index.
But maybe what people prize most about Index funds is how well they have performed over the past few years. A common belief on Wall Street is that it is tough to beat an index during a bull market. And that certainly appears to be the case with this bull market. As an example, the Vanguard 500 Index Fund (Investor Shares) has returned a stellar 15.58% annually for the past 5 years as of November 30, 2017. Many stock-focused index funds have had similarly phenomenal performance over the same period as well.
So why do I hate most index funds at the moment? Aren’t they the perfect investment vehicle for a thoroughly modern, globalized world? In a word: no. They used to be the perfect investment vehicle a few years ago. Now index funds are just financial time bombs waiting to blow your retirement dreams into tiny, shattered fragments of sadness.
First, it is important to understand that index funds are what is known in the investment industry as a passive strategy. A passive investment strategy attempts to exactly replicate an existing index without any deviation. This means that the money manager running a passive index fund has no input into which securities are purchased, held or sold. He simply mimics the index he is targeting. Once you dump your money into one of these vehicles it will be put to work immediately buying whatever is in the index.
This is exactly the behavior that most passive index investors want, but it also comes with a very negative side-effect that isn’t widely appreciated. Index funds represent a price-insensitive source of buying (or selling) pressure. In other words, it doesn’t matter how overvalued (or undervalued) the underlying index is, once a buy order is issued, the shares in the index are automatically purchased. Likewise, once a sell order is given, the shares in the index are immediately sold.
And guess what? Most of the indiscriminate, index fund-driven buying happens near stock market peaks, when the trailing multi-year performance of the indices is strong. Likewise, panic selling from index funds invariably occurs at the nadir of a bear market, when nobody cares how undervalued the companies in the indices are. Buying high and selling low is never a recipe for strong investment performance.
Of course, you might be the one person who can stand strong against the overwhelming urge to sell your index funds when the bottom falls out of the market. But even if you are, the price-insensitive buying or selling associated with the widespread ownership of index funds makes the entire stock market much more pro-cyclical than it would be otherwise. Market highs are far higher, which isn’t a good thing because you will overpay when you invest for retirement, a house or that cruise around the world. The lows are also much lower, which is bad because there is the chance you will be forced to cash out at the wrong time for reasons beyond your control.
As you might have guessed, right now the securities in most popular equity indices are egregiously overvalued. I like the valuation estimates used by the fund manager John Hussman for reference. According to one of his recent market commentaries, the broad stock market and, by extension, many passively managed index funds, are in line for somewhere close to 0% total returns annually over the next 12 years. That is an awfully long time for an investor to be sitting on dead money.
Happily, a great alternative to over-hyped index funds exists. I’m speaking about fine art and antiques of course. These beautiful, tangible assets have been perennially overlooked by professional asset managers and financial advisors because Wall Street professionals don’t have the skills, knowledge or background to properly evaluate them.
It is one of those great ironies of life that the crowd always chases bad investments while good investments languish forgotten and unloved. Currently millions of future stock market victims are furiously pouring billions of dollars they can’t afford to lose into index funds filled with securities trading at nosebleed valuations. And yet, at the same time there are many categories of fine art and antiques that are currently trading at depressed valuations.
So please, consider investing in a World War II era U.S. Naval aviator insignia, or a 19th century old mine cut diamond or even a 2016 Mexican Libertad gold coin proof set. But whatever you do, please don’t keep dumping your hard earned investment money into stock index funds, blindly expecting the great returns to keep rolling in. You will almost certainly be sorely disappointed.
