Are index funds fatally flawed?

“No one pretends that democracy is perfect or all-wise,” Winston Churchill famously said in a 1947 speech. “Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried.”

I recalled this bit of wisdom recently when two readers sent me links to articles that question the safety of index funds. Both identify genuine flaws in traditional cap-weighted index funds. But the problem—as always—is that the alternatives turn out to be worse. In this post, I’ll look at some of the arguments levelled at equity index funds. Next time, we’ll turn the focus to bond indexes.

Earlier this month, the venerable New York Times ran an article called The Ease of Index Funds Comes With Risk. The piece acknowledges the many benefits of index ETFs but then warns that “their simplicity harbors some simmering problems, which have grown more troubling in the course of the bull market in stocks.” It goes to say that “cracks in the edifice of passive investing are beginning to show.”

Experts in the article are concerned that the mere inclusion of a stock in a major index—particularly the S&P 500 of large-cap stocks and the Russell 2000, which tracks small caps—can distort its price. Companies in these popular indexes are systematically overvalued, they say, presumably because index-tracking funds are buying them in enormous volume. “The whole market is overvalued,” one fund manager says. “Index stocks are more overvalued.”

A related problem, the articles goes on to argue, is that overvalued stocks will fall harder during a correction. One professor “notes that in the October 1987 market crash, stocks that were members of the big indexes dropped 7 percent more than non-index stocks” and adds ominously, “I won’t be surprised if we see more of this sort of thing.”

You got a better idea?

Let’s acknowledge that the flaws in traditional index funds are real. Cap-weighted indexes, by definition, give a proportionally greater share to companies with high valuations. So it is absolutely true that overvalued companies will punch above their weight, while undervalued companies will exert less influence. And that’s not ideal. The problem is, who determines what is overvalued?

The premise behind indexing is not that cap-weighted indexes perfectly reflect every stock’s intrinsic value. The point is that it is extraordinarily difficult to identify which companies are overvalued or undervalued, and it is costly and tax-inefficient to put that research into practice. It’s not as easy as simply looking at a ratio like price-to-book, or price-to-earnings, as some of the article’s sources seem to imply. If it were that simple, then active mutual funds and individual stock pickers would be far more successful than they are.

As for the argument that stocks in the major indexes can be expected to suffer more in a downturn, that might be true as well. If index fund investors sell in a panic, they will be dumping all of the companies in the index en masse, with no regard to their fundamentals. But again, if you’re going to make that argument, you need to present an alternative.

One of the experts in the article has a suggestion: he argues for “a shift by investors to non-index stocks.” I wonder how an investor would put that strategy into practice. How exactly would you build a portfolio of US stocks that shied away from those in the S&P 500 (which includes the largest and most liquid companies in the world) or the Russell 2000? Would you be handpicking mid-cap and micro-cap stocks you deem to be undervalued? Is that really a strategy you want to adopt? Do you honestly believe that is less risky than an index fund?

It’s hard to understand the griping in the article. Active fund managers should be licking their chops if they think index funds are distorting stock prices, because that would present them with opportunities to exploit the chumps like you and me who are buying these things. And yet over the five years ending June 30, some 78% of all US equity funds lagged their benchmarks, according to the latest SPIVA report card. That number jumped past 86% for small-cap core and small-cap value funds.

Weighing your options

If you still feel swayed by arguments like those in the Times, there are some simple fixes that don’t involve picking stocks or rushing into the arms of fund managers who think they’re smarter than the market. One is even mentioned in the article: just use a fund that tracks a total-market index. Unlike the S&P 500 and the Russell 2000, these indexes don’t wield any influence by adding or deleting companies: they simply hold all companies of any meaningful size. The Vanguard US Total Market (VUN), with more than 3,800 stocks, does the trick nicely.

Another option is to look for an index that isn’t cap-weighted. The well-known problems with traditional indexes were the reason alternatives like fundamental indexing were created more than a decade ago. (These indexes weight companies based on factors such as book value, total sales, cash flow and dividends rather than market capitalization.) Just be aware that you’ll pay a premium: the iShares US Fundamental (CLU.C), for example, carries an MER of 0.71%, which is 10 times cost of the Vanguard S&P 500 (VFV).

Or you could simply accept that cap-weighted index funds are, like democracy, not perfect or all-wise. But they’re cheap, tax-efficient, and almost always perform as advertised. That makes them the worst investment strategy except all those other forms that have been tried.

This article originally appeared on The Canadian Couch Potato.