Are Index Funds the Right Choice?

In 1975, John C. “Jack” Bogle launched the Vanguard 500 Index Fund. At the time, this investment option was completely unique. Remarkably, nobody had ever thought to create a mutual fund that simply sought to replicate the construction and performance of the S&P 500. 

No doubt Bogle was on to something. By simply replicating the makeup of the S&P 500, he gave investors a powerful yet simple investing option.

Since 1928, the S&P 500 has averaged 10% annual gains. That’s better than pretty much any other investment vehicle — there’s not one fund manager on the planet that can boast 10% average gains over even a 10-year period. 

And that was part of Bogle’s point. Why pay a fund manager to pick stocks and build a fund based on his/her judgment when history shows that the manager will never be able to beat the S&P 500 consistently? It’s pretty obvious that if you’re paying 2% of your investment dollars to a fund manager, that manager has to actually outperform the S&P 500 by that amount in order to simply match the performance on a net basis. 

That outperformance has proved so elusive for a number of reasons. Fund managers make mistakes like everybody else. And when managers are wrong, sometimes the blowups are epic.

There are numerous examples of investment funds that have suffered catastrophic losses. Long-Term Capital Management (LTCM) is among the most famous. That fund’s Nobel Prize-winning economists seemed to have a foolproof model for making money, until Russia defaulted on its debt in 1997 and the fund literally went bankrupt. 

Index funds avoid the bad judgment issue by letting the size of the company itself determine how much stock the index fund will own. In a general sense, stock valuations are based on earnings. Historically, stocks in the S&P 500 trade with price-to-earnings (P/E) ratios of around 17. To grow, a company simply has to earn more money. So tracking the S&P 500 is a reliable way to profit from the companies that are performing well, as expressed in earnings growth. 

Index funds solve two of the biggest problems for individual investors. They offer steady performance, and they don’t eat up your investment money with fees.

That’s why they are so popular — there is currently around $3 trillion invested in Vanguard funds. Of course, Vanguard offers more than index funds. But even if we look at just index funds, the numbers are still huge…

Morningstar says that there is now $4 trillion in index funds. So why might this be a problem?

The Problem with the Crowded Trade

The biggest problem with Index Funds has to do with the companies that sponsor them — companies like BlackRock, Vanguard, and State Street, etc. These companies have tremendous exposure to the biggest companies. They are the new “too big to fail” entities. 

Consider the case of Apple (NASDAQ: AAPL). Vanguard has $34 billion in Apple stock. BlackRock (NYSE: BLK) has $23 billion in Apple stock. And BlackRock itself is valued at $51 billion. More than half of its value is tied to Apple stock. 

If we add up the top 10 holders of Apple stock, we’re talking about 22% of all Apple shares outstanding, worth around $130 billion. 

But of course, direct ownership of Apple share is only part of the story. Bank of America owns around $7 billion of Apple stock. Not too bad. Plus, BofA owns another $15 billion of an index fund that owns a lot of Apple. Apple makes up about 4% of the S&P 500, so BofA’s true exposure to Apple is closer to $7.6 billion. The same is likely true for the companies on Apple’s top 10 list…

There’s no getting around it: Apple has become a very crowded trade. And a big part of the reason is index funds. In seeking out safety, individual investors have encouraged investment companies to massively increase their exposure to America’s biggest companies. Bad things tend to happen when trades get crowded…

All it will take is for Apple to screw up once, and the S&P 500 falls, index ETFs fall, and the biggest owners of the stock get saddled with huge investment losses. And what happens when these companies get hit with big losses? Well, they might be forced to start selling other assets. When there’s forced selling, that’s when you get the kind of “market crash” declines we saw back in the financial crisis. 

Of course, that’s the worst-case scenario. There’s also a far more practical situation that you should consider when investing in index funds…

The Performance Conundrum

Apple is a pretty remarkable company. It has dominated the global cell phone market, invented the tablet, and is taking market share with its laptop computers. It has $200 billion in cash and pays a nice 2.2% dividend that it has pledged to raise every year. 

But for such a successful company, the valuation is downright cheap. It trades with a trailing price-to-earnings (PE) ratio of just 10. With the trailing P/E for the S&P 500 at roughly 20, some investors look at Apple and think it has the potential to double in price to trade in line with the S&P 500. 

That simply can’t ever happen (at least not anytime soon). Where would the ~$700 billion in investment money come from to push Apple shares higher? And if Apple shares have limited upside, that means index funds should have limited upside too, right?

Well, the fact is, index funds don’t perform as well as the S&P 500… 

Logically, you wouldn’t think it would be possible for an S&P 500 index fund to underperform the S&P 500, but they do. And I think it’s because the funds have such concentration in the really big stocks like Apple that they can’t adjust quickly enough to movements in smaller stocks. Index funds just aren’t nimble enough. 

If you want to actually match or beat the performance of the S&P 500, index funds aren’t the way to go. The best way to beat the S&P 500 is to own quality dividend stocks that are growing their dividends as sales and profits increase.

Of course, you may not beat the S&P 500 the very first year — or couple years — you adopt a solid dividend investment strategy. But if you reinvest your dividends into more stock, it won’t be long before you outperform the S&P 500 every single year. 

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.