Money

Pros and Cons of Index Funds

February 1, 2021

Pros and Cons of Index Funds

There are pros and cons to the popular investment strategy called index investing. Index funds buy every public company listed on an exchange. This is an alternative to picking and choosing stocks individually. The goal of an index fund is not to beat the market, but pace its overall return (which historically is about 10%). Index funds have been around since the 1970’s but become really popular in the last decade. Here’s why I don’t like them:

Market Cap Weighting

Most index funds use market-capitalization weighting to determine how money should be deployed. For example, if you invest $500 into an S&P 500 index fund, you’d assume $1 will be invested into each of the 500 companies, right? Wrong. If you invest $500 into an S&P 500 index fund, the largest companies (biggest market capitalization) get more than $1 and the smaller companies get less.

The image to the right shows S&P 500 weightings as of 2018. If you invest $500, Apple gets $20, Microsoft gets $13, and Amazon gets $10. The smallest companies (not shown) will get a couple cents.

Index investors conduct no due diligence. There is no review of the company’s financial statements and they don’t care about corporate policies or accountability. The incredible rise of index investing is partially why Apple, Amazon and the biggest companies in America are now worth trillions of dollars.

Is this even considered investing?

Related Reading: How to Survive Retirement

Index Funds Blindly Invest

Index funds don’t encourage investor participation. For example, let’s say you hate that Amazon doesn’t pay taxes, you refuse to bank with Wells Fargo and you drive a Prius because you’re worried about climate change. Isn’t it hypocritical that you profit from Amazon, Wells Fargo and Exxon Mobile in your retirement account? If you think socially responsible index funds eliminates that risk, you are wrong. As I write about here — ESG, Impact and SRI funds all invest in the same 12 companies:

  • Facebook
  • Google (Alphabet)
  • Visa
  • Mastercard
  • Apple
  • Exxon Mobile
  • JP Morgan
  • Johnson & Johnson
  • Microsoft
  • Amazon
  • Procter & Gamble
  • Wells Fargo

And the reason for that? Because these have the largest market capitalizations. They might pretend to care about the environment, social justice or employee pay — but let’s be honest: Wall Street is best at chasing profits. MarketWatch interviewed the CEO of an actual socially responsible investment firm who said the following:

Related Reading: How to Be a Conscious Investor

Index Funds are in a Bubble

Christian Bale plays an investor named Michael Burry in the movie The Big Short. In real life, Burry is famous for spotting patterns in the market. For example, he predicted the subprime mortgage crash and made millions off a single trade. Today, Burry is sounding the alarm on index funds. He told Bloomberg News: The rush into index funds has parallels with the 2008 bubble that about destroyed the global financial system. Index funds distort stock prices and flows will eventually reverse. Like most bubbles, the longer it goes on, the worse the crash.

To illustrate index fund popularity:

  • 2002: 4.5% of the U.S. stock market was made up of index funds
  • 2009: 9% of the U.S. stock market was made up of index funds
  • 2019: 17% of U.S. stock market is in index funds ($4.6 trillion)

Michael Burry isn’t the only one worried. Jack Bogle, the founder of Vanguard and pioneer of index funds warned the Wall Street Journal that index funds were getting too big. Bogle is concerned shareholders won’t exercise their voting rights and massive financial groups (Vanguard, Blackrock, etc.) will be the only ones holding corporate executives accountable.

Bogle has now died and his prediction is exactly the circumstance we find ourselves in today. And people wonder how the rich stay rich?

Related Reading: Is it a Good Time to Buy a Home?

4 Reasons to Avoid Index Funds

Index funds serve a purpose in the market. For example, I invested in an index fund that mirrored the broader market of a developing nation in Africa. At the time I was seeking exposure in that market but having no knowledge of the companies, I invested in an index fund instead. But there’s no reason to play so dumb in America. And if you haven’t noticed, corporations and Wall Street are taking wild advantage of your ignorance:

Your Ignorance Helps Wall Street Profit

Let’s say an analyst from Goldman Sachs predicts Netflix will report strong earnings. Based on his predication, Wall Street traders buy Netflix stock and push up its share price. A higher share price leads to a larger market capitalization which means index funds will buy more shares of Netflix than other companies in the exchange. But whoops! Netflix missed their earnings and Wall Street traders dump the stock. The share price crashes and Wall Street didn’t lose a dime. In this common scenario, index investors (unknowingly) pushed Netflix to an outrageous price that Wall Street cashed in on before dumping the stock.

The Efficient Market Hypothesis is Flawed

When Jack Bogle introduced the world to index investing in the 1970’s, his idea was based on the Efficient Market Hypothesis. The Efficient Market Hypothesis says that the share price of a publicly traded company is always accurate because it contains within it all available information about the company. If every stock is priced appropriately all the time, then investors should buy every stock instead of picking individual ones. The problem? Jack Bogle’s stock market is very different from today’s. The Federal Reserve has printed so much money — through excessive lending, quantitative easing and low interest rates — that there is nothing efficient about today’s stock market and index investing is nothing more than a Ponzi scheme.

Isn’t This Suspicious?

It’s strange that our government and the media insist we invest in the stock market when so few of us understand how it works. Ask the average American what companies he owns in his investment portfolio and he’ll give you a blank stare. It’s obvious that encouraging clueless Americans to invest into an asset class they don’t understand is a tricky way to transfer wealth from the 99% to the global elite.

No Corporate Accountability

Within 10 years over half the U.S. stock market will be made up of index funds. If everyone owns every company, who holds that company accountable? Executive salaries, corporate policy and reorganization efforts are voted on by shareholders. However, index investors give their voting rights to the financial firm where they invest. Over 80% of the trillions of dollars invested in index funds belong to just three companies: Vanguard, Blackrock and State Street. Are you really just going to look the other way?