Market Commentary - February 2019

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Index Funds and Risk

There have been a few things written over the last few weeks about index funds and a potential risk they could pose to markets and on capitalism. These arguments are not against index funds themselves but rather against the rising culture of indexing. Index funds have become an important part of a well rounded portfolio and they now make up about 17% of the total U.S. stock market value compared to 4.5% in 2002. We have mentioned in meetings with clients that this percentage is important to keep an eye on because there are some valid concerns and risks associated if this percentage increases to a much higher amount. Even then, however, I would argue the benefit to the individual investor would far outweigh the various threats.

Since index funds are passive in nature, this can lead to a handful of stocks representing a large percentage of an index. Some argue this could pose a threat to markets because if massive selling starts in a few big stocks, it can quickly accelerate. An actively managed fund can limit exposure to any individual security and minimize potential volatility. While there is some truth to this, the larger threat in my opinion stems from active managers trying to "time" markets and chase performance. During the financial crisis, many fund managers were constantly buying shares of Lehman Brothers & Bear Sterns on the way down with hopes their funds would out pace the indices once the stocks recovered. Well, that never happened and many were severely punished with poor returns. The same thing occurred during the 2011 European crisis with European bank stocks. 

Another argument against index funds is that they lead to asset mis-pricing as money is not flowing to the companies that will make best use of it. Again,there is some truth to this but if fund managers were able to consistently identify the "best" companies, they would be outperforming their respective index, not trailing, and index funds wouldn't be gaining as much traction as they have.

In my opinion, the argument that holds the most weight has to do with corporate governance. The late Jack Bogle (the "father" of indexing) himself, expressed his concerns over this very thing. A greater amount of shareholder voting power is in the hands of a few companies who are large players in index investing. Vanguard, State Street and Blackrock to name a few. This can lead to conflicts of interest when so much voting power is in the hands of a few. Generally it is better to have voting power spread out as that tends to lead to more of an even playing field for all parties involved.

The positives that index funds bring to the average investor are many. For one they tend to be a more tax efficient and cost effective way to invest and the numbers seem to back that up. According to the S&P Dow Jones Indices SPIVA study, over 86 percent of all actively managed U.S. stock funds have underperformed their index during the last 10 years. Even more, 83 percent of actively managed government bond funds underperformed their index. These percentages are staggering. It is nearly impossible to know which actively managed funds will beat their respective index in any given year. Actively managed funds almost always have higher internal expense ratios which is another hurdle they must overcome to match the performance of their respective index.

The bottom line is there is a place for both active and passive investing. Investing always takes on a multitude of risks and those risks can vary but one thing that can be achieved regardless is diversification. Like most issues that relate to the market, I think this will work itself out over time but the benefits from index funds to investors can't be denied and their rise has lead to billions of dollars saved by investors.