Wednesday, 18 September 2013

The Fundamental Problem with Index Funds

It is never a good thing to be so enamoured with a financial product or investment that you cannot see it's flaws.  All of us know this and it may feel like I'm stating the bleeding obvious however it turns out that I had one blind spot - index funds.  I love index funds - I have written about them on several occasions and they are the cheapest and easiest way for a novice investor to access the share market in a cheap way that neither under-performs or outperforms (before fees which are rather small) the market generally.

This ultimate diversification and market performance for in a low cost listed product seemed like the perfect product.  Admittedly you could never by definition do better than the market but unless you have a pressing need to earn superior returns then a portion of your portfolio should definitely be in it.

So what is the problem with index funds

From the title of this blog post and my introduction you know that there is a big fat 'but' coming up.  Nothing I wrote above is actually untrue however whenever you invest in a product you should always know what the downside is.  It turns out the downside in index funds is how the market is actually measured.

Full credit goes to Joel Greenblatt in his book 'The Big Secret for the Small Investor' which I reviewed yesterday for pointing out the one major flaw in index funds.

Almost all major index funds such as the S&P500 in the US and the ASX S&P 200 in Australia and the FTSE in the UK are market capitalisation weighted index funds.  That is the largest stock accounts for significantly more of the index than the smallest one.  I explained the difference in my post on the difference between the Dow Jones Industrials Index and the S&P 500.

Because they are weighted by market capitalisation this means that you own more of companies with larger market capitalisations and less of those with a lower market capitalisation.  The major problem with this is that if you are a value driven investor such as myself what you end up doing is (through the process of market weighting your index or by buying into one) you are buying more of the expensive in favour sectors and stocks and less of the cheap out of favour stocks.

A value investor would actually seek to do the exact opposite - you want to
buy those sectors which are currently out of favour and trading cheaply and sell those stocks which are expensive.  In fact as stocks become more expensive, an index fund buys more of them.

Although there are various solutions to this problem the further away you get from the market cap weighted index the more you move into active fund territory

There are various solutions to the problem that market capitalisation weighted index have (outlined above) such as owning equal weighted index funds or index funds which automatically screen based on valuation principles.  Each have their own pros and cons however the closer you get to a 'value' oriented fund which would be 'perfect' territory, the further away you get from having a low risk fund which tracks the market without risk of under or over performance.

I thought a lot about whether the above problem was enough for me to sell out of these funds completely and I decided that it was not.  Yes, I recognise the problem however until there is a solution which consistently delivers performance (after fees) in excess of what is offered by index funds then I am happy allocating a part of my portfolio to these funds.

I recognise the inherent 'cop out' in my above solution and if you have a better solution I would love to hear about it because I could not think of one.  It is always good to know what major downsides of any investment is and although I will continue to own index funds, I am happy that I know and acknowledge the flaw in their structure.

You May Also Be Interested In
Book review: The Big Secret for the Small Investor by Joel Greenblatt
Index funds: A cheap and easy way to invest in the stockmarket
What is the difference between the Dow Jones and the S&P500?
What does 'generating alpha' mean?


  1. There are hardly any managers on earth that have consistently beat the broad index over the span of ten years. It is not possible for you to correctly identitfy each "value" fund - which leads to a risk reward based capital market. The only downside is they are not as sexy. In gneeral, you don't have the large swings up and down.

    1. I completely agree with you! What Greenblatt was proposing in his book was the creation of a new type of index which was constructed on value metrics. This does not exist and there are massive difficulties in creating them.

      I am sticking with traditional index funds for my own investments though can now see the inherent anti-value type bias it comes with.