The Great 21st Century Index Fund Folly?

The financial fashion winds have blown many investors far into the low cost index fund forest, supercharged by the recent (and historically unusual) sustained surge in the S&P500, and encouraged by government forces since the 2008 Great Recession. The basic premise, of course, is that these funds are cheap (often but not close to always true), and that most investors – including professionals – can’t sustainably beat the indexes over time. This fashion is also referred to as “passive” investing. While indexing does indeed have some merits, Camarda believes it is far from panacea, and that wise investors should consider passing on this particular Kool-Aid. Here are some reasons why. The first one – borrowed from a WSJ article, though it should be obvious – is folks like Warren Buffett, whose investment skill drove his Berkshire Hathaway to grow 136 times as much as the S&P 500 over the 50 years ended in 2015 (WSJ 10-19-16 C2). Another is a critical point missed by most investors and advisors – that buying an index fund is not the same as buying the market the index is supposed to represent. For instance, when an index announces it’s changing its composition – dropping one stock and adding another, say – nimble players dump the old one and buy the new one fast on the announcement, and index fund investors wind up getting fire sale prices on the replaced and overpaying for the replacement. This expensive effect is invisible to investors, according to the WSJ, since the index does not report the impact until after all of these distorting trades are history. Another pitfall is that stocks in indexes tend to be overvalued compared to non-index peers, since index funds have to buy a specific index stock whether it’s a good buy or not, but active managers don’t. The bigger the index fund industry gets – and it has gotten huge and continues to bloat – the more pronounced this house-of-cards effect may get, and the investors would overpay for stocks that may ultimately deflate compared to more fairly valued alternatives. As mentioned elsewhere in the Camarda material, value investing – which can be the antitheses of index investing in many ways – is one of the few academically proven methods to target superior investment performance over the long, non-fashion-conscience term. A long term study quoted in the same WSJ article – for 1964 to 2012 – found that index investing would have produced an annual return of some 9.7%, but a simple value strategy would have yielded over 11.2%. Over the study period, that would translate into a portfolio twice the size of the index one. Fashion, most would agree, tends to be fickle, and often seems silly in the rear view mirror. Low-cost and increasingly robotic index investing, in Camarda’s view, represents profound and stealth risk for many investors, who might be better served by a proven strategy, such as a dedicated value approach – which, by the way, has been out of favor long enough to be possibly primed for significant outperformance.

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