The Pros and Cons of Index Funds

Index funds have never been more popular. But to me, they are irresponsible and lazy. Here are the pros and cons of index funds.

I work in financial services marketing.

My job is to help financial companies acquire new customers by promoting their brand on personal finance and investing websites.

As a result, I spend a lot of time on personal finance and investing websites!

If there’s anything I’ve noticed, it’s that Americans have fallen in love with index funds.

Technology and the longest bull market in history is largely responsible.

The days of paying a financial advisor to invest your money, or calling up a broker for advice, are long gone.

Technology companies built robots to do that, at a fraction of the cost.

So in my job, seemingly overnight, the advertisements for Vanguard, Fidelity and Charles Schwab were replaced with advertisements for Betterment, Acorns, and Stash Invest.

Want to guess what the robots have in common?

Robots LOVE index funds! And since investor money was flowing to the robots, the non-robots (Charles Schwab, Fidelity, etc.) also turned their attention to index funds.

And this how 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 just want to pace it.

The thing about index funds is that most 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. The purpose of the fund is to match the performance of the S&P 500. You might think investing $500 will result in investing $1 into each of the 500 companies.

That is not the case.

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:

Apple Inc.AAPL3.700338
Microsoft Corp.MSFT2.662436 Inc.AMZN1.956003
Facebook Inc. Class AFB1.898974
Johnson & JohnsonJNJ1.661317
ExxonMobil Corp.XOM1.614225
Berkshire Hathaway Inc. Class BBRK.B1.549398
JPMorgan Chase & Co.JPM1.533203
Alphabet Inc. Class AGOOGL1.336235
Alphabet Inc. Class CGOOG1.313764
Wells Fargo & Co.WFC1.160224
AT&T Inc.T1.142076

Related Reading: Do You Know *Why* You Are Investing for Retirement?

Socially Conscious Index Funds?

So now that you understand how index funds work, what happens if you hate Jeff Bezos and don’t want to support Amazon?

Or let’s say you want to invest in a socially responsible index fund. You may 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). Below is a screenshot from Vanguard that describes ESG in detail.

socially responsible index funds

If you’re this type of investor, which let’s hope you are, then index funds aren’t for you.

Index funds simply don’t have morals or opinions when it comes to corporate behavior in our country.

All index funds care about is the return. This is because the higher Wall Street investors push the stock price of a company, the bigger its market capitalization is. The bigger the market capitalization, the more of that company the index fund invests in.

This is all 100% regardless of how well that company treats its employees, how outrageous the CEO’s salary is, how sustainable their products are or how much damage they do to the environment.

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.

According to a piece written by MarketWatch, Matt Patsky, the CEO of a socially responsible investment firm, says, Investing in a simple index fund is immoral. He says index funds  make no ethical distinctions between companies based on how they act.

I agree with Matt 100%.

That said, investing in a socially responsible fund or ESG fund is absolutely no better. If this type of investing is of interest to you, please, please read my article on How to Be a Conscious Investor.

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 man named Michael Burry. Burry is a genius investor famous 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: 8 Reasons to Not Invest for Retirement

The Pros and Cons of Index Funds

I don’t have any pros for investing in index funds. If it’s a bear market and you believe a bull is coming, then  index funds could work out. But at the core, I believe in supporting (or not supporting) individual companies based on their mission, the understanding of the business, and the price in which their stock is trading.

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.

Imagine a Wall Street analyst predicts that Netflix stock is going to go higher. Professional investors therefore buy Netflix stock, which pushes up its stock price. A higher stock price means a bigger market capitalization for Netflix so index funds will allocate more money to buy Netflix.

But whoops! The company misses earnings and the stock crashes. The professionals, being professionals, got out in time. But the index fund, being a robot, bought Netflix for you at a very high price and subsequently loses that money for you 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 common sense and is 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 everything that I’ve written above into consideration 🙂

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