Mark Hulbert, a fellow MarketWatch columnist and respected observer of the financial advising business, recently wrote a thoughtful critique of the massive rush to index-style investing.
I just wish the headline had been different.
The opinion article he wrote was titled “Index funds now are part of an investor’s biggest problem.”
Widespread index investing is certainly a big change in the investment business, one long overdue and vitally important to safeguarding the retirements of millions.
A second headline, in smaller type below the first, is more accurate: “New ETFs and other products encourage stock picking and market timing.”
It feels like the fine print on fad diet products, those TV commercials that promise you’ll shed 20 pounds by the holidays just by drinking a chocolate shake a day.
Sure, the shake might be okay to drink (maybe), but you have to have the discipline not to follow it up with a bucket of fried chicken. The starlet chugging the shake looks healthy, but below her picture you will no doubt notice a stern warning: “Results not typical.”
As with dieting, investing discipline is crucial. The problem is not indexing. It’s our human tendency to game the system, to have the “diet” chocolate shake and the fried chicken, too.
Investment fried chicken
Hulbert writes that 83% of the thousands of ETFs now on the market index narrow economic sectors and even narrower investment styles — basically, the investment equivalent of sneaking fried chicken.
As Vanguard Founder Jack Bogle echoed in a recent interview, “When you get into ETFs and their rapid growth, it has certainly become a marketing business. We now have one that’s short retail and long electronic marketing.”
“Talk about a product of the times,” Bogle continued. “And we’ve got the Republican and the Democratic ETFs, and the drinkers and the distillers. And where it ends nobody knows.”
Rather than ordering a healthy, well-rounded index-fund “meal,” a portfolio that captures the broadest and most reliable returns, investors are finding ways to turn index funds into junk food.
Absolutely nobody needs thousands of ETFs any more than they need thousands of stocks to consider. Once you slice and dice small groups of stocks by economic sector into thinly traded ETFs, the diversification advantage of indexing is moot.
The narrower the fund the more costly it becomes, too, rivaling and often exceeding the cost of even the most expensive actively managed funds. High fund fees undermine the idea of index investing in the first place, which is cost reduction.
All that aside, the real problem investors run into with index funds is our human tendency to overindulge by trading anyway.
Bogle notes that turnover — the speed of buying and selling — for the average stock is 12%, while the turnover for ETFs is 880%.
For responsible portfolio managers, this ease of buying and selling an asset at a low cost can be useful when rebalancing. To those bent on speculating, however, it’s a serious risk.
“Investors face significant real-world costs if they engage in short-term market timing or invest in narrow sectors of the overall market,” Hulbert writes. “And ETFs appear to encourage these self-destructive behaviors, even as they are able to wrap themselves in the flag of being index funds.”
Speculation is a huge problem for individual investors, one that is made worse, not better, by the availability of so many tricky ETFs. Over the 20 years ending 2016, the S&P 500 Index returned 7.7% per year, according to J.P. Morgan.
The typical chicken-scarfing small investor, meanwhile, saw a return of 2.3%, just a hair above inflation.
Owning a portfolio of broad, low-cost funds that track the major asset classes one should own is the solution most people need. Like with any reasonable diet, pay attention to portion sizes and calories and you’ll be fine.
But prudent portfolio building is not a moneymaker for Wall Street, so increasingly we’re stuck with junk food ETFs nobody needs, at great risk to our own retirements.