Are Index Funds Really That Great?
Jul 30th, 2008 by Nut
You’ve heard it everywhere (including here) — index funds are one of the best ways for people to invest in the stock market and get some slow, consistent growth over the long term. You also hear that you can’t beat the market. Index funds ARE the market, so there shouldn’t be any debate right? Some people think index funds are boring because it’s easy and there’s absolutely no chance that you’ll beat the market. Others think very highly of themselves and believe they can pick out their own individual stocks and beat the market that way. Likelihood of that happening over the long term: zilch.
But if index funds are so fantastic and so popular (almost $5 trillion are indexed to the S&P 500 alone), shouldn’t it be common knowledge how those 500 companies get picked to become part of the index? You would think so, but I’ve been an index-fund investor for years and I hadn’t given it a lot of thought until I read an article about it.
The Requirements
- At least a $5 billion market cap
- Four consecutive quarters of positive earnings
- Enough liquidity — people are buying it and selling it “enough”
- Has to be a US company with no more than 50% of its assets and revenues being in the US
*To read all the details check out this document
The S&P will also remove and add companies if they’re violating any of the main requirements like profitability and market cap. The idea being to always represent the economy, so when tech stocks were so popular in the 90s, the S&P adjusted accordingly and that’s why it fell so hard towards the end of that particular bubble.
It’s Not Mindless
Isn’t it good news that there are actual requirements and rules to keep “bad” companies out of the S&P? I think it’s a great way to try to get a little bit of quality control, especially when you’re talking about 500 companies to track. But the more you read about how it all works, the more it feels like you could do better. Right now the S&P is weighted with bank stocks and if you kept up with the news, you would’ve known a while ago that that sector was hurting/going to hurt more. But if you owned an S&P index fund there’s nothing you could’ve done about it. Because it’s not an active fund, the fund would have to wait until the requirements are violated before finally selling out of those positions.
Index Funds are Boring
Let’s face it, index funds aren’t the most exciting thing out there. You don’t get the chance to read about companies or the economy and try to make decisions based on your own personal analysis. Instead, you just put your money into a formula that doesn’t promise anything other than to mirror the performance of 500 companies, minus fees and any error margins.
After thinking about this for a while, it hit me: index funds are great and I will continue to invest in them. But they could be so much better. If the “formula” was streamlined and made a little more efficient (eight straight quarters of profitability?), then we wouldn’t have to worry as much about things like tech and housing bubbles.
This whole thing brings me back to an idea I had a while ago: building your own mutual fund. If there was a company out there that functioned like a brokerage but let me build my own index/mutual fund with very low expense ratios (I guess it could be based on how many investments are in the fund), then I would join in a second. Instead of buying up the whole S&P 500, maybe I could pick the “top” 200 companies I like, getting rid of some of the sectors or companies I don’t like. That way I’m tied to the index but I’m gambling a little that I can bring something to the table (actively managing) that will put me over the top. It’s what I do now, in a way. I invest in index funds and then a little bit in individual stocks, hoping that they push me over the expected returns of the market.
What changes to the S&P 500 selection process would you make and if you could start your very own index fund, what would your “formula” be?
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This is a terrible, terrible article. First, there’s more than just the S&P 500 index. If you want a total market index fund, get a total market index fund. And the “building your own mutual fund” is just as stupid. If you want the S&P without financials, go long an S&P500 index fund and short the financials via another sector index fund. Easy. Please don’t listen to this idiot.
Of course the S&P is only one of the index funds that are out there, but by using the S&P as an example, I’m focusing on how indexes like it are compiled.
And as for your idea of shorting financials while buying the S&P, that’s one way to do it. But what if you want to buy only the companies in the S&P that start with the letter R? Don’t you wish you could build your own mutual fund now?
I’ve been doing this exact thing since Sept 07, using foliofn.com I try to stay diversified, but have overweight materials, and underweight financials. In addition, I added a touch of gold, oil and other commodity futures ETFs. My portfolio has swung wildly, but generally speaking its outpaced the S&P. Sometimes by a wide margin, and sometimes it converges. Its currently 7% above the S&P index, relative from this past February, or five months ago. Not bad. Especially considering the rock bottom expenses. FYI, my midcaps have been the star performers, which was kind of surprising.
The only thing that makes me nervous is possessing raw stocks with brokers in general. Brokers can and do fold, and I imagine that would lock up the stocks for a very long time while the government steps in to sift through the wreckage. During that time, maybe a year or two, one will not be able to buy & sell, and will be sailing the Wallstreet sea without a rudder.
Index funds are like automatic transmission. And you don’t have to worry about the broker. I may eventually switch back to those, but for now, I aim to make great riches with DIY.
[...] if you’re investing in individual stocks and not indices, that’s a whole different story. One that I shall tackle at another [...]