Index Funds Are Glorified and Overrated -What You Should Look Out For

This article originated from my blog: Investing Beanstock

Join My Tele Channel Here For Updates!

“90% of active fund managers lose to the stock market in the long run, passive investing is the way to go, you get back market returns and you beat the fund managers in the long run!” Yada yada yada.

I hear this all the time and the majority of index fund advocates are either boomers, lazy investors, religious believers of Jack Bogle or beginner investors who do not know how to stock pick properly.

Here’s what Jack Bogle, the creator of the index fund have to say about his own creation:

“If everybody indexed, the only word you could use is chaos, catastrophe, and the markets would fail.”

In recent years, investors have been ditching active managers in favor of ETFs and other index funds, which typically offer a way to get market exposure at lower fees. While I do not disagree that most investors simply need 1 or 2 ETFs and call it a day, it is still important to know what you own and why you own it.

Massive Inflows into Passive Index Funds since 2015

Regardless of one’s opinion about the merits of passive investing, the characteristics show that they are essentially “momentum” strategies, systematically buying when money flows in, and selling when money flows out.

While it is true that majority of beginners and “know-nothing” investors are better off buying an Index ETF like S&P 500 Index ETF, simply pumping money aimlessly may not be a way out as well because that would be trend following and we all know how it will end up eventually.

ETFs, as we all know, consist of a basket of stocks and are subjected to the ETF’s own mechanical constraints (i.e Market-Cap Weighted/Sector Focusing etc.), so essentially, these ETFs are basically a big fishing net scooping up everything it catches: the good ones, the mediocre ones and the poor performing ones all under the same net.

By holding an index ETF such as a US Small-Cap Index ETF, you are buying into small US companies which are great, mediocre and poor all together just like I mentioned above.

The reason why some small cap stocks are even surviving is because these index funds are providing liquidity and volume through these ETFs, which in turn help sustain “unpopular” and simply “bad” companies because everything is bundled up together under the same basket.

Going back to what Jack Bogle said; so how exactly will indexing result in chaos and the market to fail?

The reason is simple: The stock market is a dynamic environment filled with _short term speculators, traders, hedge funds, active funds, long term investors and derivatives traders _and many more which all help ensure that the stock market remains dynamic and vibrant for different strategies and objectives.

As index funds continue to balloon, price growth will no longer be a result of fundamentals but simply because of more inflows into the fund which forces ETF managers to continue pumping into the basket of stocks at higher valuations.

Since these funds are passively managed, there is no way to kick out the mediocre and poor performing stocks because they are all constituents of their respective indexes.

Too Much Of One Thing Is Not Good

Part of the effect from this trend moving beyond a healthy mix of active and passive management is that it effectively takes half of the buying power out of the market.
A good active manager may research an attractive company with terrific fundamentals, but the passive half of the market does not care about fundamentals and just buys across the board based on company size.  (subjected to whatever the ETF constraints are).

On the flip side, when investors go bearish and decide to sell, they tend to move as a group, sometimes in a huge, uncontrollable fashion.

When the herd stampedes out of the passive investments, the active half the market may not be interested in buying the entire index of stocks, and prefers to cherry pick the ones perceived to have good fundamental characteristics, which causes a huge disparity in stock prices since they are not supported by fundamentals but simply driven by momentum.

According to the late Bogle, if passive index fund investing dominated 75% of more of the entire stock market, the market could become a dangerous place as trading would dry up if only indexers comprised the stock market, and there will be no active investors setting prices on individual stocks, which can result in a total collapse of the market where the market mechanism can no longer function. (this is highly unlikely but still a possibility).

So, What To Do Now?

Fret not. Like all skills and knowledge, it is best to learn, unlearn and learn it again, because the second time you learn a new knowledge after debunking the original thesis, will help you to develop critical thinking and to understand both views to get a balanced viewpoint.

I am not saying you should not invest into index ETFs, but rather, understand why index ETF is not the way out for investing in the long run if you don’t understand its purpose because simply listening to hearsay or being a trend-follower will not bring you any real benefit.

If trend following in the stock market worked, then there should be millionaires everywhere, or even better, everyone would be as rich as Warren Buffett. But that is not the case.

Invest in your own knowledge

The thing is, most people simply wants the easy way out. They want to skip the research, skip the learning process, skip everything because they simply don’t have one drop of interest in the stock market. Does it sound like you?

If your answer is no, then great! Keep learning and understand that investing is a slow learning process, even Warren Buffett is constantly learning new things everyday even though he is the world’s most successful and prominent investor. Likewise, I am also learning new things everyday and the point is to keep learning and moving forward.

If your answer is yes, then there is only one advice for you: There are no free lunch in the world.

Yes short term trading may work in the short run of a few months to a year. But it won’t work long term. Right now, every Tom, Dick or Harry are up 300% on their portfolio of $1000, $2000 or even $100,000 if they actually bought something in 2020.

In this crazy bull run, everyone will look like a guru because of absurd returns, but then again, when the reverse happens, where do these “gurus” go?

Everyone calls themselves a long term investor until the market crashes and the sh*t hits the fan

Majority of investors will fall under this category. Again, there are no free lunch in the world. If you go 100% into NIO or TSLA and are looking at +800% returns, that is not investing, that is pure luck, which is equivalent to gambling.

Investing is never about luck because there is a strategy behind how you can invest and manage your downside risk.

And because the laws of nature will always be fair and equal, if you can get an absurd +800% in a span of a few days/weeks/months, then the reverse can happen as well when the momentum is against you.

Hence, the best protection against a “trend-following” mindset is to build up your own knowledge, discipline and understanding of the different stock market instruments, so you essential shield yourself from ignorance and being part of the herd.

ETFs on its own is a great tool to increase your wealth. But if you abuse it (by not understanding the purpose), then it will work against you.

Do your own due diligence!

Just like how you would go online and research whether you should buy AirPods 2 or the newer AirPods Pro, comparing the pros and cons, doing your research seeing where sells it the cheapest or any vouchers, you should do the same for any form of investments.

Don’t rush to buy into an ETF or stock or crypto based on hearsay and not understanding why you bought it, because in the end you are the ignorant and “trend-follower” who wanted a shortcut and because of the lack of control over greed, you FOMO-ed and became part of the herd. And you’re left asking “Did I get in at a good price? I am having second thoughts..”

This is the classic case of Buy High Sell Low, and that’s what you get for being part of the herd!

And when you are part of the herd, you either go up with the herd or go down with the herd, and your returns will speak about what kind of investor you are. So ask yourself: Do you actually know what and why you own certain investments? (be it a stock/ETF/Unit Trust/Robo/Crypto)

The best way to start is to read books, watch educational YouTube videos during your free time. Instead of watching K-drama or Netflix 24/7, spend some time to understand what exactly is an ETF, what is compound interest and the basics of diversification for example.

You need a strong foundation

Get your basics right before moving on to do other things. Like I said in my previous article, if you have never attempted algebra in your entire life and you jump straight into an algebra exam, how well do you think you will fare?

The same applies for the stock market and the world of investing (any asset class).

Alternatives if you have no interest learning yourself

If you are really not interested, you can likewise consult a competent advisor who is well versed with investing and dabbles into the stock market themselves. This is really important because the longer and more experienced they are in the markets, the more reliable the person is able to offer you sound advice.

I am available for consultations and if you are interested to learn how you can build a powerful portfolio for the long term or general advice about personal finance or wealth management, you can reach out to me here!

You can also check out my post here where I share portfolios which lazy investors can look into.

I use StocksCafe to keep track of all my investments (include Robo) + research on stocks. You can also view my portfolio as well as many others so you can compare your own performance with other investors. If you are interested in signing up, you can use my referral link to sign up and access premium features for 1 extra month for new users. (3 months)

Do you agree that index funds are overrated? Yes, No and why? I would love to hear what you think so leave your comments down below!

Happy investing and keep sowing your beans!