The Fallacies of Index Fund Investing

| | Comments (0)

It seems I can't hardly turn around in the investment world without a paean to Jack Bogle, who preaches the advantage of the index fund.

Mr. Bogle's reasoning goes something like this: Looking at the world of mutual funds, relatively few funds beat the S&P 500 Index, so why not just buy the whole S&P Index?

This is nothing short of the most successful sales pitch based upon a straw man argument in history.

Index funds are huge. Mr. Bogle's own original fund is the largest mutual fund, and both of the two largest mutual fund families base their pitches (in large part) upon their large number of Index Funds based upon various indices. That's how successful the pitch has been.

What Mr. Bogle doesn't tell you is that Index funds aren't the Index either.

There's a bit of Red Herring in the argument also. Index Funds aren't some ideal investment package that doesn't have expenses. They may be low (21 basis points per share for the biggest the last time I looked), but they are there. So in an ideal universe, they lose to the index by this amount. Plus they do have the same need managed funds have to hold some cash. Since the market goes up about 72 percent of the time (over the course of historical years), and they lose an amount of gain or loss proportional to their cash holdings, over time they lose more than they gain on this. By comparison, the measurement made of managed funds is after all such inefficiencies.

In other words, the Index Fund sales pitch reduces to "Most of these other finds don't beat this measurement. Come to us where you're guaranteed to fall short!" The thrust of their sales pitch is holding themselves out to a a perfect idealization, which in fact they are not.

There are other reasons to avoid Index Funds. The most famous, best known and largest are all built upon the S&P 500 Index. This is a market capitalization based Index. The Fund buys into these companies based upon market capitalization. It should be no surprise to anyone that this means that whatever the largest company in S&P is, it will be several times the size of number 500, so the funds investment in them will be correspondingly weighted, while having zero investment in number 501. This means (because Index funds are such a large portion of the overall market) that Index Funds cause demand for those companies which are a member of this universe to have larger demand than they otherwise would, therefore artificially inflating the share price of those companies somewhat.

Now, one of the reasons people gravitate towards mutual funds is instant diversification of investment. You put in your $1000, and because it's is in turn invested as a part of a much larger investment pool, you have much more diversification than you would otherwise be able to purchase with that same investment were you to purchase stocks directly. One of the reasons I worked almost exclusively with mutual funds (and mutual fund-like) when I was in the business is that if you want to build a diversified direct stock portfolio in an efficient manner (buying whole, as opposed to odd share lots), it takes about $100,000. This is more than most folks are willing or able to invest in a single shot.

But one of the open secrets of the mutual fund industry is that many, if not most, funds are over-diversified. Their holdings are so diluted that when they pick a winner, their shareholders see comparatively little benefit because they've made too many bets. When you bet 100% of your money and the stock doubles, you get 100%. When you bet 1/500th of your money and the stock doubles, you get 0.2%. This dilution effect is directly proportionate to the number of investments (bets) they have made, while the benefits of diversification are only proportionate to the square root of the number of investment holdings they have. In other words, the fund with 400 holdings is sixteen times more dilute than the fund with 25, but only four times as protected by diversification. One of my favorite fund families, in which I myself continue to invest for other reasons which outweigh this, had 432 holdings in its growth fund the last time I got a report. That is way too many. Mathematical models have determined that the optimal number of holdings for a fund is in the range of twenty to thirty, getting good protection of diversification while not suffering from over-dilution of good investments. I am becoming, more and more, a fan of "focus" model funds, where the investment managers are forced to be choosy by limiting the overall number of investments to a certain number of securities.

Index funds typically have way too many funds to qualify for this. Of all the major indices, only the Dow Jones ones have a small enough base to be considered as having a near optimal number of components. I just don't hear about people wanting to invest in those. 20 Transportation? 15 Utilities? They're derided as sector investments, and not good ones. 30 Industrials still seems to have some cachet, but by comparison with S&P 500 or even the Russell Indices (1000, 2000, and 3000), the amount invested in Dow Industrials is microscopic. Perhaps because it's not a "true" index, but is selected by the publishers of the Wall Street Journal, theoretically for the components representation of the entire market.

Index funds are not without their benefits, of which their mindless vanilla nature is probably the greatest. If you want an investment you can just make and not watch and not worry about unless the entire asset class tanks, Index funds are fine (S&P is large cap blend). For market-timers, index funds are unmatched, particularly since their cost of putting the investment in and taking it out tends to be low. But I am not a mindless vanilla investor, and for one step up the mental chain, index funds can be beaten by periodic investment class reallocation. Furthermore, I am an investor, not a market-timer. So any time somebody's recommendations for investing include index funds, I'll pass those recommendations by.

Caveat Emptor.


Delicious Bookmark this on Delicious StumbleUpon Toolbar Stumble It!
Please be civil. Avoid profanity - I will delete the vast majority of it, usually by deleting the entire comment. To avoid comment spam, a comments account is required. They are freely available, and you can post comments immediately. Alternatively, you may use your Type Key registration, or sign up for one (They work at most Movable Type sites) All comments made are licensed to the site, but the fact that a comment has been allowed to remain should not be taken as an endorsement from me or the site. There is no point in attempting to foster discussion if only my own viewpoint is to be permitted. If you believe you see something damaging to you or some third party, I will most likely delete it upon request.
Logical failures (straw man, ad hominem, red herring, etcetera) will be pointed out - and I hope you'll point out any such errors I make as well. If there's something you don't understand, ask.
Nonetheless, the idea of comments should be constructive. Aim them at the issue, not the individual. Consider it a challenge to make your criticism constructive. Try to be respectful. Those who make a habit of trollish behavior will be banned.

Leave a comment

Copyright 2005-2022 Dan Melson All Rights Reserved

Search my sites or the web!

The Book on Mortgages Everyone Should Have
What Consumers Need To Know About Mortgages
What Consumers Need To Know About Mortgages Cover

The Book on Buying Real Estate Everyone Should Have
What Consumers Need To Know About Buying Real Estate
What Consumers Need To Know About Buying Real Estate Cover

Buy My Science Fiction and Fantasy Novels!
Dan Melson Amazon Author Page
Dan Melson Author Page Books2Read

Links to free samples here

The Man From Empire
Man From Empire Cover
Man From Empire Books2Read link

A Guardian From Earth
Guardian From Earth Cover
Guardian From Earth Books2Read link

Empire and Earth
Empire and Earth Cover
Empire and Earth Books2Read link

Working The Trenches
Working The Trenches Cover
Working the Trenches Books2Read link

Rediscovery 4 novel set
Rediscovery set cover
Rediscovery 4 novel set Books2Read link

Preparing The Ground
Preparing the Ground Cover
Preparing the Ground Books2Read link

Building the People
Building the People Cover
Building the People Books2Read link
Setting The Board

Setting The Board Cover

Setting The Board Books2Read link

Moving The Pieces

Moving The Pieces Cover
Moving The Pieces Books2Read link

The Invention of Motherhood
Invention of Motherhood Cover
Invention of Motherhood Books2Read link

The Price of Power
Price of Power Cover
Price of Power Books2Read link

The End Of Childhood
End Of Childhood cover
The End of Childhood Books2Read link

The Fountains of Aescalon
Fountains of Aescalon Cover
The Fountains of Aescalon Books2Read link

The Monad Trap
Monad Trap Cover
The Monad Trap Books2Read link

The Gates To Faerie
Gates To Faerie cover
The Gates To Faerie Books2Read link

C'mon! I need to pay for this website! If you want to buy or sell Real Estate in San Diego County, or get a loan anywhere in California, contact me! I cover San Diego County in person and all of California via internet, phone, fax, and overnight mail. If you want a loan or need a real estate agent
Professional Contact Information

Questions regarding this website:
Contact me!
dm (at) searchlight crusade (dot) net

(Eliminate the spaces and change parentheticals to the symbols, of course)

Essay Requests

Yes, I do topic requests and questions!

If you don't see an answer to your question, please consider asking me via email. I'll bet money you're not the only one who wants to know!

Requests for reprint rights, same email: dm (at) searchlight crusade (dot) net!
Learn something that will save you money?
Want to motivate me to write more articles?
Just want to say "Thank You"?


Add this site to Technorati Favorites
Blogroll Me!
Subscribe with Bloglines

Powered by FeedBlitz

Most Recent Posts
Subscribe to Searchlight Crusade

About this Entry

This page contains a single entry by Dan Melson published on May 14, 2006 10:01 AM.

Winning The Election of 2006 and Beyond was the previous entry in this blog.

Links and Minifeatures 05 15 Monday (late) is the next entry in this blog.

Find recent content on the main index or look in the archives to find all content.


My Links