Are Index Funds Dangerous?

We’ve written about the fact that indexing is a simple, sensible strategy for average investors that can capture core returns in a tax-efficient and low-cost way. It’s a method that’s likely to beat the typical performance-chasing behaviors that plague the average active investor.

Buying the S&P 500 Index is usually better than chasing the recent top-performing fund, though it is never an optimal strategy, because it misses most of the potential benefits of diversification. Our white paper on successful portfolio management is clear-eyed about the limitations of indexing. As we observe in our white paper, no professionally-managed college endowment, corporate pension plan, or foundation is ever 100% committed to the S&P 500.

There are some times when a sensible strategy becomes worrying simply because of its popularity. Mutual fund powerhouse Vanguard, the first firm to offer an S&P 500 Index fund, recently noted that passive investing now represents over one-third of all mutual fund flows. If we add in “closet indexers” that pretend to actively manage portfolios, but actually hug the index closely, something approaching half the equity fund marketplace is heavily committed to the S&P 500 Index.

Hence our concern. Like Yogi Berra, we suspect that today’s most popular restaurant may turn out to be crowded with all the wrong people. Even worse, if an event sends the diners stumbling for the exits, it is likely that the large number of people trying to leave at the same time will cause injuries at the exits.

Enough analogies. Whenever too many people chase the same investment, it creates portfolio risk. That remains true even when the popular asset is a broad index. For example, from 2000-2003 the S&P 500 Index fell 45%, even though the median stock within the index actually gained in value. The total collapse of a small number of tech stocks dragged down the entire index.

In a recent US News & World Report article about passive investing, TGS Financial’s Portfolio Analyst and Chief Compliance Officer, Phillip J. Deerwester, advises investors that “setting an allocation and forgetting it forever is too passive.” He points out that even passive strategies need adjusting as investors’ time horizons and risk levels change.

With the median S&P 500 stock now much more expensive than in late 1999, and the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google/Alphabet) accounting for more than 100% of the S&P 500’s total upward move since 2015, risks are high.

Owning the S&P 500 Index is simple, cheap, and tax-efficient. It’s a reasonable, though not optimal, long-term portfolio strategy. It is never a low-risk strategy, and right now it looks pretty darn dangerous to us.

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