Avoid the Siren Call of Index Funds

In mythology, the Sirens were beautiful yet dangerous creatures. They lured sailors to their doom with their enchanting music and voices – causing them to wreck their ships on the nearby rocky coast.

Fast forward to today, and investors are facing similar circumstances to those sailors of long ago. Only now it’s the siren call of index funds that threatens to “shipwreck” investor portfolios in the current rocky investment climate.

A climate – I might add – that my 30 years’ experience in the investment business, tells me will continue for a very long time.

Why?

Because central bankers “magic” seems to be losing its “mojo.”

Close Your Ears to Bogle’s Call

Investors today are bombarded with siren calls of how passive investing – index funds – is the way to go. Just put your investment plan on autopilot and you’ll end up well off in retirement.

The loudest of these voices is John Bogle, the Chairman of Vanguard – which he founded in 1974.

But that’s to be expected. In Wall Street parlance, he is “talking his book.” His business, with about $3 billion under management, relies mainly on index funds for its existence.

Today, more than $1 in every $5 invested is in index funds. And Bogle wants all five of those invested dollars to be invested with Vanguard.

He continuously forecasts the demise of active stock-picking funds.

And Bogle certainly has the performance data on index funds to back him up over the past decade. In the 10 years through 2014, Morningstar says passive funds outperformed active funds with returns of 9.27% versus 8.05%.

But investors need to realize that the recently ended period is one that probably won’t be repeated. Ever.

Markets came to believe in the omniscience of central bankers. Stocks, particularly larger ones, all floated higher on the flood of liquidity from the fed and other central banks. Trying to swim against that tide and outperforming by picking individual equities was like spitting into the wind.

In 2015 and so far in 2016, passive funds are lagging. Central banks’ policies seem to be losing their stimulant (like a drug) effect.

Index Funds Flying Blind

The main effect of this drug was that the stock market was never really able to do price discovery on stocks. You couldn’t distinguish the good companies from the bad. Everything – especially large caps – went up.

Index fund managers furthered this trend. They buy exactly what’s in the index and don’t care about any of the companies’ fundamentals. I liken it to flying a plane blindfolded, and just hoping autopilot does the job.

Another flaw with most index funds is that they’re weighted by market capitalization. By definition, index funds own the most overvalued stocks in the stock universe.

Think of the FANG stocks last year and how they rocketed up to prominent positions in the S&P 500. They’re not doing so well this year. Nor is Apple Inc. (AAPL), which is now down 30% from its highs.

You’re supposed to “buy low and sell high.” Not the opposite, which is what index funds do for investors.   

Former Fed Official Warns Investors

I’m not alone is my disdain for passive index funds.

After leaving Wall Street, Danielle DiMartino Booth spent nine years at the Dallas Federal Reserve. She served as an advisor on monetary policy to Dallas Fed President Richard Fisher, and became known for sounding an early warning call on the housing bubble in the early 2000s.

Today, Ms. Booth has a consulting firm called Money Strong.

She recently penned a fabulous article titled “Paying the Pied Piper of Passivity,” which focused on index funds. I urge everyone to read it.

In it, Booth compares those who run index funds, like John Bogle, to the Pied Piper of Hamelin.

But unlike that story, where the children disappeared forever, she warns that “investors must reckon with the systemic risk that permeates the markets when boom turns to bust.”

Booth went on, “Maybe a bit more business cycle and less artificiality would have left investors in a better place. One thing is for sure – there wouldn’t have been the wholesale herding into passive funds these past few years.”

That “artificiality” is, of course, the Fed and other central banks giving the markets all the “drugs” it needed every time the market sneezed. But my belief is that the effect of those “drugs” is diminishing with every dose administered.

Finally, Booth said, “Market behavior suggests that an entire generation of passive investors is about to discover the downside risk of holding highly concentrated positions that have flown blind, free of price discovery.”

It’s still not too late though. Investors still have time to steer away from those rocky markets and away from the call of those passive funds’ siren voices.

Take the advice of legendary investor Sir John Templeton. He said, “If you buy the same securities everyone else is buying, you will have the same results as everyone else. By definition, you can’t outperform the market if you buy the market.”

Investors are going to want to outperform the market – as defined by the major indexes – in this current period.

Good investing,

Tim Maverick

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In mythology, the Sirens were beautiful yet dangerous creatures. They lured sailors to their doom with their enchanting music and voices – causing them to wreck their ships on the nearby rocky coast. Fast forward to today, and investors are facing similar circumstances to those sailors of long ago. Only now it’s the siren call...

Tim Maverick

, Senior Correspondent

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