Are Index Funds Dangerous?

While focusing on the Federal Reserve’s quarter-point interest rate cut, you may have missed an interesting milestone in the investing world: For the first time ever, U.S. index (passive) mutual funds have more money invested in them than active, stock picking funds. The margin is slim, according to Morningstar, passive index funds had $4.27 trillion in assets as of August 31st versus $4.25 trillion in actively traded funds that attempt to beat the market.

Sure, this is just for the U.S., and index funds still lag the global stock and bond markets, but investors have slowly come to understand what Vanguard founder and father of the index fund, John Bogle once explained: “Because of the costs of managing funds, the management fees, the operating expenses, the marketing costs, the sales loads, the hidden costs of portfolio turnover, the net return earned by the average fund must fall short of the return earned by the market itself.”

Indeed, year after year, research has found that the vast majority of active mutual funds fail to beat the indexes against which they are measured. And importantly, the funds that manage to beat the index, rarely consistently do so.

But recently, there have been murmurs that index fund popularity could be dangerous. I have usually ignored these Cassandras, thinking that those “warning” of the problems are from the actively managed world and therefore, are biased.  But when someone like Dr. Michael Burry starts ringing the alarm bell, we all should listen. Burry was one of the few investors who correctly recognized and predicted the crash of the subprime mortgage market (he was the Christian Bale character in the movie version of Michael Lewis’ The Big Short). Burry now says that index funds have some of the same characteristics of the toxic securities that caused the world financial crisis. Yikes!

Burry believes that those of us who pour money into index funds are not attempting to discover the underlying value of the stuff inside of the index. Additionally, we may not realize that it would be very difficult to get out of the funds in a downturn, which might cause even more selling, especially in more thinly traded small stocks. The rush to the exits would be exacerbated because of the use of options in some leveraged mutual and exchange-traded index funds.

This all sounds pretty terrible, so should you abandon index funds? I don’t think so. Call me jaded, but I think the active/professional manager’s ability to judge value is not so hot. As Barry Ritholtz put it: “Analysts are too bullish when things are going well and too bearish when they are not.”

As far as the stampede towards the exit, it might be crowded for active traders, but for the rest of us long term investors, the big impact of index funds is having to endure more volatility, which we’re already doing right now.

There is a bigger, and more dangerous problem, for long term investors: we are still attempting to time the market! According to research firm Dalbar, last year the average stock mutual fund investor endured a loss of 9.42 percent compared to an S&P 500 index that retreated only 4.38 percent. “In 2018 the average investor underperformed the S&P 500 in both good times and bad.” Those who may have seen trouble coming and sold, were not smart enough to know when to get back in.

By the way, 2018 was not an outlier. Compared with the S&P 500, through December 31, 2018, here investors underperformed by 5.88 percentage points, annualized, over 30 years. In other words, the fault is not in our stars, or our index funds, but in ourselves.