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The Pros and Cons of Index Funds

Last updated on May 18, 2020

The Pros and Cons of Index Funds

The days of paying a financial advisor to invest your money are long gone.

Technology has infiltrated the wealth management industry and displaced a huge chunk of the workforce.

The shift happened at the beginning of the longest bull market in history.

What has been the result?

Obviously the robots, which invest primarily in passive index funds, have been made to look like geniuses!

Who needs a human to invest?!

As more and more Americans jumped on the index/robot/passive bandwagon, the traditional firms followed suit and created their own version of automated investment solutions.

And Americans across the country forked over billions to invest without ever talking to a human.

This is why the US stock market now has over $4 trillion invested in index funds.

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 the same return.

Some years the return will be higher, some years it will be lower. But instead of trying to beat the market by buying and selling individual stocks, index investors seek to pace it.

What I don’t like about index funds is the use of 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 might think this would result in investing $1 into each of the 500 companies, right?

Not true.

Instead, 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 from 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

There is no due diligence, there is no vetting of executives, there is not even a review of 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: How to be a Conscious Investor

Socially Conscious Index Funds?

But what happens if you hate Jeff Bezos and don’t want to support Amazon?

Or let’s say you care deeply about the environment, how employees are treated or what political organizations a company supports.

What then?

This type of investing is called socially responsible investing or ESG investing (Environmental, Social, Governance). This is how Vanguard explains ESG:

socially responsible index funds

I don’t recommend investing in index funds if you’re a socially conscious investor.

I say that because index funds don’t have morals or opinions when it comes to corporate behavior in our country.

Index funds are chasing a return.

The higher Wall Street investors push up a company’s stock price, the bigger its market capitalization. The bigger the market capitalization, the more of that company the index fund invests in.

This is 100% regardless of how a company treats its employees, how outrageous executive salaries are, or how sustainable their products are.

See Exxon Mobile in the list of S&P weightings?

Exxon Mobile a massive, corrupt and unethical company that 99% of American investors are gladly supporting and profiting from in their portfolios. Perhaps even while protesting Rex Tillerson on the steps of the White

Matt Patsky, the CEO of a socially responsible investment firm, says that investing in a simple index fund is immoral, in an article on MarketWatch.

He says index funds make no ethical distinctions between companies.

But what about all the socially responsible index funds? Can’t I just pick a ESG fund that aligns with my values?

Believe it or not, you can’t.

In How to Be a Conscious Investor, I expose the truth behind ESG and “socially responsible” funds.

Hint: They are a total scam.

Michael Burry and the Index Fund Bubble

Did you watch the movie The Big Short?

Do you remember the character played by Christian Bale?

He played a guy named Michael Burry, who is a genius investor known for spotting patterns in the market.

His latest observation? That index funds are just a bubble bound to burst. This is what he told 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 the rise in index fund popularity:

  • 2002: 4.5% of the U.S. stock market was made up by index funds
  • 2009: 9% of the U.S. stock market was made up by 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 funds
Related Reading: Is a 401k Worth It?

The Pros and Cons of Index Funds

One reason to invest in index funds is if you can time the market and get in towards the beginning of a bull market.

This is exactly why the last 10 years have been so fabulous for index investors. They pat themselves on the back for having no morals, taking no responsibility for which evil corporations they are supporting, and go on with their lives as their portfolios rise in value.

If the stock market crashes? Well we haven’t seen the end of that story yet….

Why Index Funds are Bad Investments

#1. Market Capitalization Weighting

The bigger the company, the more money the index fund allocates to that company. In other words, the more expensive the stock, the more of it the index fund buys. Investopedia explains it nicely here.

Let’s say a Wall Street analyst predicts that Netflix stock is going to rise. Professional investors then buy Netflix stock, which pushes up its stock price. A higher stock price means a bigger market capitalization for Netflix. Thus, index funds will allocate more money to buy Netflix.

Makes zero sense.

But whoops! The company misses earnings and the stock crashes. The professionals, being professionals, got out in time and sold their positions. But the index fund, being a robot, bought Netflix for you at a very high price and then loses your money when the stock crashes back down.

#2. The Efficient Market Hypothesis

The philosophy behind index investing as a movement is called the Efficient Market Hypothesis.

Efficient Market Hypothesis says the share price of a public company is always “correct” because it contains within it all relevant information about that company. Because every stock is priced appropriately at all times, investors are better off buying every single stock instead of picking and choosing individual ones.

I vehemently disagree with this outlook and do not believe that every stock is priced appropriately at all times.  There are dozens of companies trading today at levels far beyond what they are worth as a business. This theory doesn’t follow logic and is totally wrong.

#3. The Loss of Investment Integrity

Investing didn’t used to be something every American did.

In fact, 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.

And 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 and understanding the product they sell. It used to mean examining financial statements, and assessing profit margins.

It used to actually take work! And there was joy in that when the investment paid off.

These days, however, Americans give their money to a robot and use the stock market as an ATM. Oh, you’re saying I own shares in a public company? And I have rights as a shareholder? Never knew that! 

Related Reading: Do Shareholders Still Have Rights?

#4. Corporate Accountability

Within the next 10 years, over HALF of the U.S. stock market will be made up of zombie index funds.

If everyone owns a piece of every public company, who holds that company accountable?

Being a shareholder is being an owner. A shareholder has voting rights on how the company should be run. Index investing strips away the element of participation.

Over 80% of all the money (trillions) invested in index funds belong to just three companies: Vanguard, Blackrock and State Street.

In other words, the index investor gives up their voting rights via index funds, and these three companies speak on their behalf.

“When you see a small handful of players with ever-growing share and ever-growing clout affecting the trajectory of the largest public companies in the world, that’s going to raise a lot of eyebrows,” says Ben Johnson, a Morningstar Inc. analyst.

“The question is whether their influence will be wielded for better or worse.”

How corporations are run is just as important as how the government is run. Do you really want to trust a massive multinational and billion dollar company to vote on your behalf?

You trust them?

In Summary

Index investing has been around for decades. For a knowledgeable investor who follows the stock market, index funds can serve a purpose within a portfolio.

For example, I once wanted exposure to companies from specific regions in Africa. Since I’m not familiar with that part of the world, I invested in an index fund that mirrored the markets of regions I was interested in.

These days, however, index funds have become synonymous to investing.

If you’re someone who cares about the environment, buys organic and local products, engages in political protests, etc. — then you are a total hypocrite if you also invest in index funds. Index funds are made up of the largest US corporations, including many of which you are protesting against or boycotting at the store.

Where is your accountability? Where is your participation? Giving up complete control of your money to those on Wall Street will backfire, because newsflash, Wall Street doesn’t have your back.

The technical reasons for disliking index funds comes down to market cap weighting, the flawed Efficient Market Hypothesis on which it is based, lack of integrity and The Big Three owning 80% of the market.

I’m not alone in my suspicion of index funds. Famous investors such as Michael Burry have come out ringing the alarm of the trajectory of this trend. He calls it a flat-out bubble and I completely agree.

Where did all the money go from Quantitative Easing? I can’t help but see a correlation in the Fed printing trillions of dollars and the US total stock market capitalization increasing by trillions of dollars.

All that said, black swans exist. The stock market and index funds could keep going up forever and forever. The world is complex, globalization is new, and I am not a professional.

But at least take what I’ve written above into consideration 🙂

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!

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