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Like Most Investment Tools, Index Funds Aren't Perfect

If you’ve searched for any sort of investment advice within the past half-decade, you’ve heard about index funds — cheap mutual funds that use algorithms to mirror certain broad market indexes, like a basket of the 500 largest U.S. companies known as the S&P 500. Because there is no real overhead to run an index fund, they’re cheap. And because of that, many think they are the perfect investment.

While index funds are valuable securities for individual investors, they are not perfect, or even the best, options.

Index Funds Do Not Provide Different Strategies for Bull and Bear Markets

Different markets (bull and bear) call for very different strategies. Even if your objectives are modest and you are mostly seeking to capture the long-term upward trend of the market, it is one thing to ride a bull, and another thing entirely to ride a bear. 

Index funds are passively managed mutual funds that — in contrast to actively managed funds that try to beat the market — use a set formula to mirror the market, or a particular segment of the market (sometimes called a benchmark). For example, the first index fund, still one of the most popular, is set up to mirror the S&P 500 (the 500 biggest companies in the U.S., as measured by total capitalization).

The argument for these funds goes something like this: You’re an investor who is serious about building real long-term wealth. You’re not content to simply ride the market. With at least some of your investments, you’d like to outperform the market, and you are willing to pay higher fees for the opportunity to do so. On the other hand, you don’t have the time or inclination to research individual stocks, and you’re willing to pay someone a reasonable fee to do that homework for you, in return for a decent chance that they will be able to beat the market over time. (For related reading, see: Can Regular Investors Beat the Market?)

During the bull market of the 80s (1982–1987) and 90s (1987–2000), this was a great deal, and it became an attractive and increasingly popular option with investors. Mutual funds routinely reported returns in double figures, and high-profile fund managers like Fidelity’s Peter Lynch (who, over a 10-year period, beat the S&P 500 by an impressive 150%) achieved almost superstar status. Hundreds of new funds were created and the competition between them was intense — yet more people were winning than losing.

When the Dotcom Bubble Burst

But then the dotcom bubble burst, followed by a decade with big gains at some times and big losses at others. It now appears that the 90s were the exception rather than the rule, creating unrealistic expectations about the stock market in general, and mutual funds in particular. Moreover, a growing number of studies started questioning whether the performance of actively managed funds justified their higher fees.

John Bogle, the founder of Vanguard and creator of the first popular index fund, has been arguing for passive investing since the 1970s. In 1995, even while actively managed funds were flying high, he wrote an article entitled “The Triumph of Indexing.” And as of 2010, his boast seemed to have come true. Increasingly, investors have been taking money out of active funds and putting them into passive indexes.

Passive vs. Active Management

Moreover, a number of studies appear to support the case against active management. Foremost among these is Standard & Poor’s comparison of index and active funds — the SPIVA Scorecard (S&P Indices vs. Active). Issued twice a year, the most recent scorecard for 2015 finds that 66% of large-cap, 57% of mid-cap and 72% of small-cap active funds failed to meet their benchmark (the index they would track if they were passive funds). The numbers are even worse when extended over a 10-year period. S&P also issues a persistence scorecard to assess whether funds are able to maintain above-average short-term performance over time. Again, the numbers aren’t pretty. Of the 678 domestic equity funds that were in the top quartile (25%) in September 2013, only 4.28% were similarly ranked two years later. (For related reading, see: Why Your Passive Fund Is Crushing Active Managers.)

Why Fund Managers Can't Seem to Beat the Market

Why are expert fund managers, with all the research tools in the world at their disposal, so consistently bad at beating the market?

  • Size –  Simply put, the bigger a ship, the harder it is to change course. Markets are cyclical and investors can become irrational. The best investors learn to quickly adjust, and to protect their portfolio from market extremes. Large funds are for the most part unable to do so. Also, because of their size, investing in small, dynamic companies often isn’t worth the trouble—effectively shrinking a fund’s universe of investment-worthy stocks.
  • Psychology –  Fund managers are generally compensated based on how they perform relative to their benchmark, so they often have an incentive to play it safe and simply try to stay even with (or even slightly behind) the pack, as opposed to trying to beat the market. This herd mentality is especially evident during a heated bull market. If a given index is surging (such as what happened with tech and internet stocks in the late 90s), the majority of managers end up riding the wave and investing in the same popular stocks (in the business we call this “chasing performance”).
  • Timing – Sometimes the smartest investing move is the non-move: knowing when to hold off, rather than (in baseball terms) swinging at a bad pitch. Professional fund managers usually don’t have this luxury. As new money comes in, they can’t just sit on it, even if they suspect the market is overvalued and overpriced. It’s a particular problem during a bull market when, because of recent performance, a fund attracts a lot of new investors — a phenomenon called forced buying. Timing can adversely affect investors another way. A fund might, for instance, report a 20% annual return in a good year. But, unless you were on board from the beginning, you’re not going to see all or even most of that. Individual investors also chase performance, jumping on the bandwagon of a hot fund not at the bottom, but as it nears its peak. One study estimates that this “timing penalty” costs individual investors 5% in returns each year. (For related reading, see: Market Timing Tips and Rules Every Investor Should Know.)
  • Concentration (not enough of it) – The limits of diversification are nowhere more evident than in the world of mutual funds, especially the biggest, most popular ones. Despite studies showing the benefits of diversification drop off greatly once you hit 20 to 30 stocks, many funds insist on maintaining dozens, even hundreds of holdings. At a certain point, this “excessive diversification” (as some call it) is self-defeating: you end up mirroring the market and losing any chance of beating it. And, if all you do is match the market, your returns (once you factor in the higher fees charged by active funds) are bound to disappoint.

Portfolio Drag Index

Analyst and fund manager Thomas Howard also questions the conventional wisdom about the underperformance of actively managed funds. His research concludes the returns of such funds are held back by three factors he combines into a Portfolio Drag Index. Closet indexing is the most significant of these, followed by overdiversification. Related to both is a third he calls “asset bloat.” Fund managers are not only compensated based on performance relative to a benchmark, but also on how big the fund is: total assets under management (AUM), as it’s known in the industry. As the fund grows and (over)diversifies, the quality of its investments becomes diluted. Howard finds most of a fund’s chance for superior performance can be found in its first 20 investments: these are its best ideas, its “high-conviction” picks. But, with the average fund now comprising over a hundred holdings, it has four or five times more low-conviction stocks than high-conviction ones.

Most investors are not served by an either/or approach. A number of high-profile articles have appeared in the last year or two offering a contrarian view to the prevailing wisdom that index funds are necessarily superior. And, while Vanguard is known for championing passive indexing, about half of its funds are actively managed. In some years those active funds outperform its passive ones, and Vanguard has conducted extensive research on the keys to a successful active fund.

The point of examining funds and the ongoing debate about the merits of active vs. passive management is not because I think they are necessarily the best investment vehicle available to you but because they are a popular and easy way to get your feet wet in the market. And if that’s what it takes to start exposing yourself to the greatest wealth-accumulating tool known to man, the stock market, by all means invest in index funds.

But just understand they’re not the perfect investment. Different markets call for different strategies. In its simplest form, indexing means riding the market; it’s an entirely different thing to ride a bull than a bear. (For related reading, see: 5 Things You Need to Know About Index Funds.)