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In recent years, index investing has become very popular. As a layman, who enjoys personal finance and reading about investing, the benefits of index investing have been firmly advised in the articles and investing philosophy of many financial commentators. The appeal of index investing is seen in arguments that state if you buy an index you will save money on fees and that percentage of savings on fees will make a big difference in your overall returns. Additionally, they argue that by investing in an index you are guaranteed to get average returns of the market and not experience anything worse than that. Mutual funds are believed to be too expensive in fees and that by being actively managed they risk performing worse than the overall market.

Recently, I came across author Nicholas P. Cheer on http://www.seekingalpha.com, who wrote a serious of articles which argues against the dogma of index investing and recommends investors would be better served by choosing quality mutual funds to indexes like the S&P 500.

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how do people consider it a wise way to invest to mindlessly shovel money into companies based on market-cap without any consideration of valuation? Index investors fail to see stock for what it is; a share of a corporation. The price you pay values the companies future cash flows, when participants ignore the price paid for those future cash flows, they put themselves squarely outside of the world of investing and enter the world of speculation.

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Index Funds are Expensive
This is true in more ways than one. First off, the Vanguard Total Stock Index (MUTF:VTSMX) currently trades at 26.9x earnings. A deeper look at market valuation shows that this is the second most overvalued period behind the 2000 tech bubble. This is not a prognostication on where stocks go from here - I have no crystal ball - but it is an indication of where we are in terms of valuation from a historical context.

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Index funds ignore the laws of investing. By buying all the securities in a given market and then weighting them by market cap, an investor owns both the good and the bad within a given market. This ignores the research of Fama/French, Novy Marx and others who have identified a significant premium for investors who weight their holdings towards the quality factor. Buying quality firms, with excellent balance sheets and wide moats provides an advantage for investors over the long run. In addition the notion that one should hold an entire market means that all the constituents are worth holding when in reality they may not be. The notion that we cannot weight a portfolio by excluding the poorly run companies and including companies that exhibit higher characteristics of quality, size, and value factors, is ignoring academic research, and creating a rather irrational approach to investing.

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Index funds make no sense. The entire concept of buying more and more of a security as it gets more and more expensive makes absolutely no sense. Would you buy more houses as they become more expensive, or more of anything else? Likely not. There is a point at which the price versus the value would become unattractive for investment purposes. Yet index funds ignore economics by continuing to funnel capital into stocks, regardless of earnings or any other metric of company value.

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Investors fail to understand that true active management is a misnomer, and true active managers are not very active at all. Value investing is more about patience than activity. In reality, a better way to invest is to know what you own and why you own it. Go through the process of selecting individual securities that are purchased with a margin of safety, and hold completely uncorrelated assets to reduce risk in the portfolio.

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The author shows the superior returns of quality mutual funds:

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1976-Today.
•Mairs & Power Growth total return:13,898.95%
•Vanguard S&P 500 Index total return: 6,722%
1992-Today
•Vanguard Total Stock Market Index Fund (MUTF:VTSMX) Since inception(04/27/1992): 859.06%
•Mairs & Power Growth (04/27/1992-YTD): 1,783.19%.
What about international Markets:
2001-Today
•Vanguard Total Intl Stock Idx Fund (MUTF:VGTSX): 107.95%
•Dodge & Cox International Stock Fund (MUTFODFX): 216.63%
What about international small cap:
2009-Today
•Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEARCA:VSS) Since inception 04/02/2009-YTD: 136.84%
•Brandes International Small Cap Equity Fund (MUTF:BISMX): 327.03%
•DFA International Small Cap Portfolio (MUTFFISX): 176.50%
Both forms of active management again beat the standard index alternative.

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Further examples of mutual funds that beat the index are discussed in more detail in his other article https://seekingalpha.com/article/4086731-beat-index

Another author, Howard Love, writes :

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The primary weakness stems from the fact that almost all of the index funds are weighted according to the market capitalization of the underlying companies that comprise the index. This means that the larger the market capitalization of a company, the more it influences the index. So when an investor puts $100 into a S&P 500 Index fund that is comprised of 500 individual companies, it is mandated that Apple gets $3.85 of that, Google gets $2.80, Microsoft gets $2.60, Amazon gets $1.90 and so on. But the representation of the 500 companies varies substantially, with over half of the 500 companies in the index getting $.10 or less. News Corp, which is one of the smaller companies in the S&P Index, is allocated less than a penny.

The net result of this forced allocation is that it puts a disproportional percentage of the fund into an increasingly small number of stocks. The larger the market cap these stocks get, the more investment funds they automatically garner. Note that this allocation is not an investment decision reached by sanguine money managers. Rather, it is mandated simply by the formula that defines the index, which is weighted according to the market capitalization.

How concentrated are these indexes now? The top 5 companies in the S&P 500 index are 13% of that index and the top 25 stocks are 34%. The top 5 companies in the Nasdaq 100 Index, which is represented by the QQQ ETF, comprise a whopping 42% of that index. Even the so-called “total market indexes” from Vanguard and others have very high concentrations. In the Vanguard Total Stock Market Index, 5 companies (Apple, Microsoft, Amazon, Facebook and Google) comprise 10% of the portfolio, and 25 companies are 28%. This is hardly a “total stock market” representation. What’s even more alarming is that the same 5 companies (all tech stocks) are the top holdings of pretty much ALL of the stock market index funds.