Press "Enter" to skip to content

The Pros and Cons of Index Funds

Last updated on August 8, 2020

The Pros and Cons of Index Funds

This rise in index investing started in 2009 — the same year the US stock market entered the beginning of the longest bull market in history.

In case you aren’t familiar, index investing is money invested passively, not actively.

So instead of a human hand-picking stocks to buy, an index fund will buy every public stock listed in the target exchange. People prefer this because it saves them on fees that would otherwise go to a human.

Index investing has exploded in recent years. It’s been around since the 1970’s but startups like Betterment and Acorns brought it to the mainstream and now it’s the preferred strategy for even established firms like Fidelity and Blackrock.

In fact, as of 2020, the US stock market has over $4.6 trillion (!) invested in index funds, the most ever recorded in history.

How Index Funds Work

The goal of an index fund is to mirror the performance of the overall stock market, or a specific category within the stock market.

Since the stock market has historically returned 10% annually, index investors are seeking that same return, on average. Some years the return will be higher, others it will be lower, but instead of trying to beat the market, index investors want to pace it.

One thing I don’t like about index funds is that they use market-capitalization weighting. This means that the largest companies receive the largest pieces of the pie.

For example, let’s say you invest $500 into an S&P 500 index fund. You would think this means investing $1 into each of the 500 companies, right?

But that’s not how it works.

If you invest $500 into an S&P 500 index fund, the largest companies (biggest market capitalization) will get more than $1 and the smaller companies will get less.

Here are the weightings for the S&P 500 Index Fund (2018) to give you an idea:

Company Symbol Weight
Apple Inc. AAPL 3.700338
Microsoft Corp. MSFT 2.662436
Amazon.com Inc. AMZN 1.956003
Facebook Inc. Class A FB 1.898974
Johnson & Johnson JNJ 1.661317
ExxonMobil Corp. XOM 1.614225
Berkshire Hathaway Inc. Class B BRK.B 1.549398
JPMorgan Chase & Co. JPM 1.533203
Alphabet Inc. Class A GOOGL 1.336235
Alphabet Inc. Class C GOOG 1.313764
Wells Fargo & Co. WFC 1.160224
AT&T Inc. T 1.142076

Since humans don’t manage index funds, there is no due diligence and no one even reviews the company’s financial statements. Is it a public company? Then the index fund will buy it.

Is it a really big public company? Then the index fund will buy a lot of it.

Related Reading: 8 Reasons Why a 401k is Not Worth It

Are you a Socially Responsible Investor?

Since passive investing strategies mirror the broad market, it is hypocritical for index investors to demand corporate change from the same companies they profit from in their portfolios.

For example, what if you hate that Amazon doesn’t pay taxes? Or let’s say you care deeply about the environment, how employees are treated or what political organizations a company supports.

How does an index investor reconcile those values?

Wall Street’s solution is “socially responsible” investing or Environmental, Social, Governance (ESG). This is how Vanguard explains ESG investing on its’ website:

socially responsible index funds

Unfortunately these are lies.

Despite the marketing copy, investors are hard pressed to find any index fund — socially responsible or not — that doesn’t invest in the following companies:

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

I write more in depth about this here but the point is that the higher Wall Street traders push up a company’s stock price, the bigger its’ market capitalization and the bigger its’ market capitalization, the more of that company every index fund will buy.

The reason is because index investors are chasing an average return. A “socially responsible” index fund is not going to generate the same 10% annual return if it can’t invest in the world’s most profitable companies such as JP Morgan, Amazon, etc.

Sad but true.

MarketWatch interviewed the CEO of a socially responsible investment firm who said that “investing in a simple index fund is immoral and the funds make no ethical distinctions between companies they buy.”

So would State Street, Vanguard and Blackrock — the three largest wealth management companies in the country — mislead investors to keep their business?

green investing

Related Reading: How to Be a Conscious Investor

Michael Burry and the Index Fund Bubble

Do you remember the character Christian Bale played in the movie The Big Short?

He played the part of a real life genius investor named Michael Burry. Burry is famous for spotting patterns in the market and recently went on the record warning people about index funds (Bloomberg News):

The recent flood of money into index funds has parallels with the pre-2008 bubble that almost destroyed the global financial system. Index fund inflows are distorting prices for stocks and bonds. The flows will reverse at some point. Like most bubbles, the longer it goes on, the worse the crash will be. 

To illustrate his point, here is how index funds have increased in popularly over the last few decades:

  • 2002: 4.5% of the U.S. stock market was comprised of index funds
  • 2009: 9% of the U.S. stock market was comprised of index funds
  • 2019: 17% of U.S. stock market is held by index funds, that’s over $4.6 trillion

pros and cons of index fundsThere are negative consequences when that much money is being blindly invested into the stock market.

In fact, Jack Bogle, who is the founder of Vanguard and the pioneer of index funds in the 1970’s, sounded the alarm in 2017 that index funds were getting too big. Bogle’s concern was that shareholders would no longer exercise their voting rights and massive corporations (i.e., Vanguard, Blockrock, etc.) would be the only ones left in America to police corporate executives.

He is right. A public company is more than their profit margins and investors of that company should hold them accountable.

Or else this won’t end well.

Related Reading: Why Do Investors Give Up Their Voting Rights?

The Pros and Cons of Index Funds

All of this said, index funds can be great if you want exposure to a particular industry that you aren’t comfortable with enough to select your own stocks.

For example, I once invested in an index fund that mirrored the broader market of a developing nation in Africa. It sounds random, but I wanted exposure to that market at the time and buying an index fund made the most sense.

For many index investors today, they pride themselves on being an index investor because they bought the US broader market indices at the beginning of the bull market (2009) and have seen excellent returns.

I would be proud, too!

But that doesn’t mean index funds are perfect. If you are politically active or involved in fighting corporate injustice, then it is hypocritical to be an index investor. Besides, this bull market can’t last forever.

Here are other reasons why not to invest in index funds:

Market Capitalization Weighting

Let’s say an analyst predicts Netflix will report better earnings than expected. Wall Street traders buy Netflix stock based off this prediction and push up its’ share price. A higher share price leads to a larger market capitalization so the index funds buy more of Netflix than other companies.

But whoops! Netflix misses earnings and the professional traders sell the stock immediately. The stock crashes. In this very common scenario, the index fund used your money to buy Netflix at an outrageous price because no human with common sense is around to advise otherwise.

The Efficient Market Hypothesis

When Jack Bogle introduced the world to index investing in the 1970’s, his idea for the strategy was based on the Efficient Market Hypothesis. The Efficient Market Hypothesis says that the share price of a public company is always correct because it contains within it all relevant information about that company. Therefore, since every stock is priced appropriately at all times, investors are better off buying every single stock instead of picking individual ones. I couldn’t disagree with this logic more. There are hundreds of companies trading today at levels far beyond what they are worth as a business. EMH is just plain dumb.

No Integrity

I find it strange that our government and the media insist that Americans invest in the stock market, when it’s common knowledge few of us understand the stock market or how it works. Moreover, index “investors” aren’t participating at all. Ask the average American what companies they own in their retirement account and they’ll give you a blank stare.

Investing used to mean researching the company, learning about its founders, the mission and understanding the product they sell. It used to mean looking at the company’s financial statements. But not anymore. People give their money to a robot and use the stock market as an ATM without giving a damn about the consequences.

Corporate Accountability

Within the next 10 years, over half the U.S. stock market will be comprised of index funds. If everyone owns every company, who holds that company accountable?

Decisions such as executive salaries, corporate policy and reorganization efforts are often voted on by the shareholders. Index investors give their voting rights to the financial firm through which they invested. Over 80% of the trillions of dollars invested in index funds belong to just three companies: Vanguard, Blackrock and State Street.

Do people actually trust these companies to do the right thing?

Related Reading: Why are Liberals So Stupid?

Summary

If you’re someone who cares about the environment, buys organic and local products, engages in political protests, etc., then you are a hypocrite if you outsource your entire investment portfolio to an index fund.

America’s bull market could run for another ten years and index investors will come out looking like geniuses. But at what cost? When even the pioneer of index funds has raised a red flag, I think it’s only fair for you to consider your options.

There is a weird pressure in America to invest in the stock market. But no personal finance class required in school? Why not teach a basic How the Stock Market Works to kids in high school? It’s odd that the American public is expected to invest in an asset class that our government knows for certain we don’t understand.

Just food for thought. Thanks for reading.

One Comment

  1. Alvin Behun Alvin Behun May 2, 2020

    Everything is very open with a clear explanation of the challenges. It was definitely informative. Your website is very helpful. Thanks for sharing!

Leave a Reply

Your email address will not be published. Required fields are marked *