The Case Against Index Funds

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By Charles Sizemore

You have to love John Bogle, the founder of the mutual fund family Vanguard.

By eliminating active management and pioneering passive indexing, Bogle has saved his investors untold billions of dollars in fees, all while boosting their returns as well.

Even Warren Buffett – arguably the greatest active manager in history – has given his seal of approval to Bogle’s approach. Buffett has repeatedly said that most investors should simply buy and hold an S&P 500 index fund and forget about trying to pick individual stocks.

Bogle was a true revolutionary, and the index funds he popularized are fantastic long-term investments. Except they’re not… or at least not always.

Index funds essentially win by not losing. Because they tend to trade infrequently, they avoid excessive taxes and trading costs. That’s a major plus.

Index funds also tend to have management fees that are a fraction of their actively-managed competitors, and every dollar saved in management fees is effectively a dollar gained in returns.

All of this explains why index funds are hard to beat in long bull markets and why Buffett embraced them.

But bear markets and markets that are showing a rotation or change in leadership are a completely different story. These are the times when a value strategy beats the pants out of an index fund.

Remember, most index funds tend to be cap weighted, meaning that the largest companies by market capitalization have the largest weighting in the index.

Apple – with a market value of $840 billion – has the largest weight in the S&P 500 at just shy of 4%. The FAANGs – Facebook, Amazon, Apple, Netflix and Google – the large-cap tech stocks that have really pushed the market higher in recent years, collectively make up about 12% of the S&P 500. And if you toss in Microsoft, that number pushes above 15%.

In an equally-weighted index, these six names would make up a little over 1% of the total. But in a cap-weighted index, they make up a staggering 15%.

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Now, all of that is fine and good… so long as today’s trends continue indefinitely into the future.

But when has that ever happened?

At the peak of the 1990s internet bubble, tech stocks made up a mind-boggling 35% of the S&P 500. But when investors dumped expensive tech stocks and rotated into traditional value sectors in the following decade, tech’s weighting fell to less than 15%.

It’s back up to 25% today.

In 1990, the financial sector was about 8% of the S&P 500. During the mortgage financing orgy of the 2000s, the sector exploded higher to become 22% of the S&P 500, only to collapse and fall right back down to 8% during the Great Recession.

Nobody had any interest in energy stocks in 2000. They barely made up 5% of the S&P 500. They exploded to 16% in 2008, only to slide right back down to about 7% today.

The problem with putting money into an index fund is that you’re always overweighting the most expensive and overbought stocks.

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In 2000, you should have sold expensive tech stocks and loading up on cheap financial and energy stocks. (A lot of smart value investors did exactly that, by the way, and made out like bandits even while the broader market was falling.)

Likewise, in 2000 you should have exited expensive banking and energy stocks and looked to rotate back into unloved tech.

But index investors stayed overweighted on the aging leaders… and effectively rode them all the way down.

I can’t say for sure that we’re on the verge of another major change in market leadership. But I can say that the market overall is expensive and very much due for a deeper correction or bear market. And tech stocks have once again become a very crowded trade, while energy and materials stocks are cheap and under-owned.

The problem with a pure value strategy is that cheap stocks can continue to get cheaper, sometimes for years. You’re unlikely to call the bottom with any precision. That’s just the cold, hard truth of investing.

But by focusing on value stocks that are trending higher, you don’t have to play the dangerous game of catching the proverbial falling knife.

By staying ahead of everyone else, you can also keep your own personal bull market going, and going, and going.

This is exactly what I talk about in my new free presentation, “Our Never-Ending Bull Market Discovery.” Thousands of readers have already signed up. Don’t miss out!


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