Pros and Cons of Index Fund Investing

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In 1974, John Bogle was a manager at a middling mutual fund in New York who decided to leave the company and start something new. Bogle was far from a titan of industry or a household name, even among the inner circle of Wall Street elite. But he and the company he was about to start would quietly grow to become one of the most dominant financial forces in the world.

Today, Vanguard holds roughly $4 trillion in assets under management, making it the world’s largest provider of mutual funds, according to publicly available information. As explained in an article from Bloomberg Businessweek, much of this can be attributed to Bogle’s revolutionary approach to investing, although neither Bogle nor most of his contemporaries would likely use such a strong word.

Whether it’s through a mutual fund, exchange-traded funds or many other instruments, almost anyone with money tied up in equity investment does so with the help of Bogle’s index model. It’s still a strikingly simple and effective approach for the majority of average investors. At the same time, it involves some risks that have only recently come to light. Students in the Masters of Science in Finance online program at Northeastern University’s D’Amore-McKim School of Business will learn how to balance risk and return using a variety of asset types.

How investing has changed

Although Vanguard and countless firms like it have reaped incredible rewards since 1974, the very nature of financial investing has changed even more dramatically in that 40 year time period. Wall Street’s wealth has soared to unfathomable heights as well as experienced crippling loss. In part thanks to recent pop culture touchstones like “The Wolf of Wall Street” and “The Big Short,” it’s not hard to suspect most of the American public views the world of finance like intergalactic aliens would view a new planet.

At the same time, it’s never been easier for the average American to participate in the financial markets, in part thanks to index funds. According to statistics from the Investment Company Institute (ICI), approximately 22 percent of household financial assets were held in mutual fund investment firms of some kind. In 1980, this figure was just two percent. The ICI credits this trend to the advent and widespread adoption of defined contribution retirement plans, like IRA and 401(k) funds. These funds, through the use of indexing, have made it easier and less expensive for ordinary Americans to save for retirement. In return, financial institutions and the businesses they support have seen an influx of capital. The total value of all retirement assets in the U.S. rose from $7 trillion in 1995 to $24 trillion in 2015, much of those funds helping to grow American businesses.

Of course, the wider use of indexing to invest in mutual funds and ETFs for long-term savings is just one way that the very nature of finance has changed in recent decades. With the growth of the internet and related services, it’s entirely possible anyone could invest in any financial instrument available on the public market. Or if they would rather not stake money on individual stocks, anyone is still capable of monitoring the performance of any publicly traded asset, and get second-by-second updates on how it’s being bought and sold. Like in so many other ways, technology has become both a blessing and a curse to investors, particularly the average American worker contributing to a 401(k).

Recent market behavior and the limits of indexing

If one was to look back on the last 30 years of the 20th century, it would be hard to argue that a simple, index-based investment strategy was not among the safest, most rewarding bets to be made. According to Sebastien Page, head of asset allocation for T. Rowe Price, the U.S. financial markets have never posted a 15-year loss since before the Great Depression began in 1929. Even after the numerous crises that have dealt hard blows to markets in the last 16 years, this remains true, but with several caveats.

Namely, one problem with index funds concerns asset diversification. When someone buys into a mutual fund or ETF using indexing, their money is pooled and distributed to a variety of securities with at least one main thing in common. Funds tied directly to major market indices like the S&P 500 or the Dow Jones are common. Investors in these funds pay very few fees, but are beholden to generally slow growth.

As explained by several financial experts who spoke with The Wall Street Journal (WSJ), the passive index model tends to paradoxically discourage asset diversity.

“Telling investors that passive index funds are always preferable to actively managed funds reminds me of the old saying that every problem looks like a nail when the only tool you have is a hammer,” business writer J.J. Zhang said, according to WSJ. “Such thinking is extremely limited and, at times, counterproductive.”

Zhang and others argue that by focusing solely on index funds, as many laymen investors do, doesn’t necessarily protect them from risk as much as it prevents them from investing rationally. While many index funds spread investments over a number of different industries and categories, they still tend to only be American companies operating in highly competitive markets. These funds may grow steadily along with the economic performance of their home country, but usually pale in comparison to gains in developing nations like Brazil, India and China. It’s here where even more value is locked up, yet too many retirement funds won’t touch them because they simply don’t fit the index.

“Though active funds pose challenges, especially in finding funds with the right goals, methodology and operational design, they can offer the same or better benefits with more rewarding opportunities than pure passive indexing permits,” Zhang wrote.

There’s another, easier-to-explain reason why index funds might not work for some. In a humorous exchange on a finance news radio show, financial manager James O’Shaughnessy relayed a story about another index fund giant, Fidelity. According to O’Shaughnessy, Fidelity found that its highest-performing investment accounts were owned by people who did not remember they even had an account in the first place. Direct deposits had accumulated interest and dividends for years without a withdrawal.

While the accuracy of this story is disputed, it speaks both to the power and the limitations of indexing as an investment strategy. With enough time and willpower, it might be the safest retirement savings bet of all. At the same time, investors could be missing out on even better returns from a smart, scrupulous money manager or actively managed funds.

 

Recommended Readings

Best Practices for Managing REITs in an Investment Portfolio

Introduction to Derivatives

Northeastern University Online MSF Program