FA Center: Index funds now are part of an investor’s biggest problem (MarketWatch.com – Top Stories)

FA Center: Index funds now are part of an investor’s biggest problem

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Not all index funds are created equal. This is an important reality for both investors and financial advisers, but it has become especially so in recent years as the number of index funds has mushroomed. Believe it or not, there now are more than 2,000 index funds from which to choose.

It’s ironic that this number has grown so large. In the original and purest sense, there would need to be only one index fund, benchmarked to the entire stock market. That’s because the theory behind creating an index fund was to buy and hold the stock market over the long term, period. That meant avoiding two practices: Stock selection (picking individual stocks or sectors that you think will outperform the market as a whole) and market timing (periodically going to cash in hopes of avoiding bear markets).

The situation today is far removed from that original purpose. The creators of most of the recently introduced index funds (much less their investors) have no intent of avoiding those two practices. And this in turn has led to much confusion about what is involved in investing in an index fund.
























The drift away from the index fund’s original intent had already begun before the advent of exchange-traded funds, but exchange-trade funds opened the floodgates. Hundreds of ETFs have been created in recent years that focus on narrower and narrower sectors of the market. Those ETFs are index funds, but that’s where the similarity to long-term buying and holding ends. By focusing on a small subset of the entire market, investors in those ETFs are in effect engaging in stock selection. And by frequently trading them, they are engaged in market timing.

Jack Bogle, Vanguard’s founder and the creator of the original index fund, the Vanguard 500 Index Fund












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   says the difference between traditional index funds and these narrowly-focused ETFs is so great that it becomes a “difference in kind” rather than of mere degree: “The difference, if you will, is between long-term investment and short-term speculation,” Bogle wrote in his book, “The Clash of Cultures: Investment vs. Speculation.”

The chart below tells the story in greater detail. It shows the percentage of ETFs and traditional index funds that are not broadly diversified. For example, 83% of available ETFs are benchmarked to narrow sectors or investment styles, representing 54% of all ETF assets. The percentages are lower among traditional index funds, but still significant: 62% and 20%, respectively. (These percentages come from an analysis of Morningstar data by the Bogle Financial Markets Research Center, reflecting data as of November 2016.)


























This discussion is important not only to clear up semantic confusion. Investors face significant real-world costs if they engage in short-term market timing or invest in narrow sectors of the overall market. And ETFs appear to encourage these self-destructive behaviors, even as they are able to wrap themselves in the flag of being index funds.

One study that found evidence of this is forthcoming in the academic journal Review of Finance, entitled “Abusing ETFs.” The authors analyzed the trading histories of almost 8,000 investors at a German discount brokerage firm, finding that the traders who introduced ETFs into their portfolios performed worse than those who did not. The authors found evidence that the reduction in returns was caused both by the poor performance of the narrow sectors represented by the ETFs these investors purchased, as well as their market timing decisions.

Financial advisers need to be especially aware of these self-destructive behaviors today, given the push to allow ETFs to be included in the smorgasbord of options available in 401(k) plans. While it’s a hard sell denying investors the right to invest their retirement portfolios in anything they want, it’s worth asking what’s the point of adding ETFs? It would seem that it serves no purpose other than to enable plan participants to engage in shorter-term trading and/or make narrow sector and style bets.

The bottom line? If you want to live up to the original theory behind creating an index fund, buy and hold one that is benchmarked to all (or substantially all) of the entire stock market and has a low fee. Examples include the Schwab Total Stock Market Index Fund












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  , with a 0.03% expense ratio, and the Vanguard Total Stock Market Index Fund, which (provided you have a minimum investment of $10,000) has a 0.04% expense ratio.

If you want instead to engage in stock selection or market timing, be my guest. Just don’t claim you’re living up to the original theory behind investing in an index fund.

For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com .

 






























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December 6, 2017 at 02:20AM