Passive Market Indexing – Great Innovation, but Not Perfect

Low cost, passive market-cap indexing is an invention that seems almost perfect. It allows investors to enjoy the returns from the stock market without having to guess which stocks will rise (just own them all in proportion equal to their market value!) and without paying much for investment advice. The beauty of passive indexing is that for a small fee (be careful, not all index funds are low cost), the fund will track a stated index and you’ll only trail the underlying index by approximately the amount of the fees. You won’t have to worry about under-performing the market. All in all, the index fund has been a great invention and has served investors quite well. That said, while indexing solves many problems, there are two major issues – it doesn’t solve a big existing problem and its structure has created a serious new problem.

Big Existing Problem

What determines the return that an investor receives? Well, it’s a combination of the underlying returns of the investments used and the investor’s own behavior. It turns out that many (dare we say most?) investors are their own worst enemies – they tend to buy more of a fund after it has done well, sell some when it has performed poorly or even exit completely after a market downturn.   If you buy high and sell low, your investment returns will lag the funds you are invested in. The type of investment you use does not matter and index funds are not immune. Poor investor behavior can turn an otherwise good return from any investment into a mediocre return. There is nothing about the low-cost, market tracking nature of an index fund that changes this and an investor who just focuses on low costs can completely unwind all the benefits and then some with poor investing behavior. The only real solution to this is to either develop positive investment behaviors and/or to find investments that do not allow you to exit them at the worst possible time.

Serious New Problem

If investors are buying high and selling low with disastrous results, then why are index funds that do the same so popular? When money is added to a market-cap index fund, 2015-07-image2the fund just buys more, in the exact same proportion, of what it already owns. Thus it blindly invests money without regard to whether the underlying investments are cheap or expensive. Normally this might be fine as the number of cheap vs. expense stocks might cancel each other out. But in extreme situations, the higher a stock goes, the more the fund buys (buying high) and the lower a stock falls, the less the fund owns (selling low). Occasionally this blind investing can expose index investors to market distortions and undesirable risks. A great example of this is the story of Cisco Systems back in 2000. Cisco Systems, with a market value of $600 billion, was the largest stock in the world based on its market capitalization at the peak of the technology bubble. Just 30 months later, $500 billion of Cisco’s market value had evaporated and index fund investors as a group were estimated to have lost $100 billion in Cisco. It turns out that the solution to this structural problem of buying high and selling low is quite simple – just break the link between a company’s market value and its weight in an index.

The invention of the low cost, passive market-cap index fund was a great invention, and despite its structural drawbacks, it maybe better for many investors than most of the other investments options available today. That said, investors do not have to buy high and sell low, either willingly or unwillingly. With the right behavior and index products that are structurally sound, an investor can seek to buy low and sell high!

Important Note: These materials are provided for informational purposes only.  Please do not assume that any information contained in this Insight serves as the receipt of, or as a substitute for, personalized investment advice from Madison.