[bacon]

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.

[scorpion]

The theory behind indexing is that picking a mutual fund is essentially a crap shoot. You may pick a fund that returns more than the index, or you may pick a fund that returns less. On average, if you invested in ten funds, you'd likely generate the same return as the index. Except you'd be paying a higher expense ratio for the privilege of being actively managed. Paying a .80% expense ratio or higher on a mutual fund versus a .07% on an index fund results in a six-figure difference over the long term.

The graph showing mutual fund returns towering over index returns is laughably dishonest. Of course with hindsight its not difficult to find a few mutual funds that significantly outperformed the index. That's child's play. The trick is picking the mutual fund that's going to outperform the index for the future. Historical returns tell us nothing. You're falling prey to survivorship bias. The mutual funds that are around today are simply the ones that haven't been shuttered because they kept losing money (this is most funds).

I wouldn't really consider indexing the be-all, end-all strategy of investing. It's simply the best way for the average investor (who isn't particularly financially savvy and who doesn't have a lot of time to put into investment research) to invest his money over the medium and long-term. I mean, what's the alternative? Index funds are statistically proven superior to mutual funds on an average basis. So do you just buy a mutual fund and hope to get lucky and beat the average? In that case, if you just want to rely on luck, why not simply buy a single stock and hope for the best? Hell, why not just go down to the nearest casino and lay it all on black?

There's a reason that you see pushback in the financial press/sector against indexing: because it significantly eats into their profits. It also makes most fund managers look like complete idiots and reveals that all their research and trading is for the most part worthless, because on average they can't beat the market over the long term. This means that their service is less than useless because they are charging you money while producing zero net benefit. They are essentially parasites.

There is some reasonable criticism of indexing in regards to the excess weight it places on the highest market cap stocks in the index. But there are plenty of ways around this. You aren't limited these days to a simple S&P 500 market index. There are hundreds of ETF indexes you can buy that cover a wide range of market caps, countries/regions, sectors and investment types. This means you could buy "South American mid-cap" ETFs or "U.S. high-yield corporate bond" ETFs or "Gold and silver mining" ETFs, etc... This gives you significantly more flexibility in regards to your allocations and doesn't lock you in to simply owning a mini-slice of the entire market. It just allows you the benefits of a diversified portfolio without having to pay ridiculous expense ratios to mutual fund managers for absolutely no reason.

[teflon]

I've often thought about this as well. You have virtually every person in corporate america blindly investing in the same stocks in the same proportions. Seems a bit sketchy to me.

A solution I use:

https://www.guggenheiminvestments.com/et...weight-etf

This is an equal-weight S&P 500 ETF. They also have one for the Russell 2000. Fees are .40% vs the .08% or so you'll have at Vanguard for a cap-weighted ETF like SPY. However, it has outperformed the cap weighted version, including fees, 83% of the time in a 5 year period and 100% of the time over ten years. It seems that the longer the timeframe and greater the sample size of stocks involved, the better these equal weight ETFs function.

It is much less heavily weighted towards tech stocks. Consumer discretionary is represented most heavily.

Unfortunately it doesn't seem like there are many options for international investing, but the US has the biggest economy anyway.

Maybe split this with a bond fund like BND, rebalance annually, and you'll probably do well for almost zero effort.

[Jaydublin]

Passive index investing is great but I imagine there will be some sort of consequences to so much money and so many uneducated investors piling into the same stocks in this manner.

On the other side it will create some great opportunities for stock pickers. One consequence could be a larger number or mutual funds start beating the passive funds over the next 10-20 years.

[Yeti]

"As of 2014, index funds made up 20.2% of equity mutual fund assets in the US."
https://en.wikipedia.org/wiki/Index_fund

So about 20-25% of the entire U.S. stock market. That means that the market is still dominated by active trading.

Still, I wonder what will happen if enough people put their money into index funds. It feels like the current high prices in stocks have something to do with the rise in popularity of index funds.

[MrTickle]

I've held a mixture of passive and active funds over the last 5 years. All passive ones have done well and kept pace with main indexes. One active fund has beaten the lot (because fund manager is one of the few with a good track record) and then other active funds have either stayed level or growth has been well below the main index such as S&P 500. The issue with all the active funds I have held is that they all start with a strong disadvantage in that the fees are so much higher than the passive funds. Thus they have to do so much better just to stay level with the main index.

During a recent rebalance I dropped the nonperforming active funds and reshifted them into the passive and the one remaining good active fund.

Will be interesting to see if the active fund is still in the lead in 5 years time.

[Hypno]

OP's idea makes sense but it doesn't work in practice - most actively managed mutual funds under perform the index. Now, often times its only slightly, because of the higher fees, but sometimes its by a lot. What is left off of the pretty graph in post no. 1 is the thousands of funds that underperformed the index or closed their doors. That is a headscratcher known to modern finance for decades.

There are few things that work, but the idea that Teflon suggested is margingally better. What most people don't know is that the indices are dominated by the largest, most expensive stocks, because they are value weighted. There is more of SPno.1 than SP500 in the index, a lot more. But an equal weight index has been shown to work.

The media makes it seem like stock picking is the key to wealth, when it is not. Instead, working hard, living below your means, and allocating to assets properly is the key. For example, stocks right now are relatively expensive in the U.S. so this is not a good time to add to stocks. Instead, look for things that are relatively inexpensive. Commodities, for example. The problem right now is there are few things that are inexpensive.

[Sonoma]

Fees absolutely destroy investments, and index funds are a really good way to avoid them

[Kissinger2014]

The main advantages of index funds is (a) low costs (b) removing or limiting poor emotional reactions to market gyrations. I've been investing for 15 years, and have read probably 25+ books on behavioral finance and I still make the same mistakes that they warn you about (doubling down, anchoring on a high price, etc).

Joel Greenblatt, one of the greatest investors of this generation, also highlighted the issue with market-weighted indexes. His solution: equal weighted.