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Are Index Funds Dangerous?

 

We’ve written about the fact that indexing is a simple, sensible strategy for average investors that can capture core returns in a tax-efficient and low-cost way. It’s a method that’s likely to beat the typical performance-chasing behaviors that plague the average active investor.

“Nobody goes to that restaurant anymore because it’s too crowded.”

(often attributed to Yogi Berra)

Buying the S&P 500 Index is usually better than chasing the recent top-performing fund, though it is never an optimal strategy, because it misses most of the potential benefits of diversification. Our white paper on successful portfolio management is clear-eyed about the limitations of indexing. As we observe in our white paper, no professionally-managed college endowment, corporate pension plan, or foundation is ever 100% committed to the S&P 500.

There are some times when a sensible strategy becomes worrying simply because of its popularity. Mutual fund powerhouse Vanguard, the first firm to offer an S&P 500 Index fund, recently noted that passive investing now represents over one-third of all mutual fund flows. If we add in “closet indexers” that pretend to actively manage portfolios, but actually hug the index closely, something approaching half the equity fund marketplace is heavily committed to the S&P 500 Index.

Hence our concern. Like Yogi Berra, we suspect that today’s most popular restaurant may turn out to be crowded with all the wrong people. Even worse, if an event sends the diners stumbling for the exits, it is likely that the large number of people trying to leave at the same time will cause injuries at the exits.

Enough analogies. Whenever too many people chase the same investment, it creates portfolio risk. That remains true even when the popular asset is a broad index. For example, from 2000-2003 the S&P 500 Index fell 45%, even though the median stock within the index actually gained in value. The total collapse of a small number of tech stocks dragged down the entire index.

In a recent US News & World Report article about passive investing, TGS Financial’s Portfolio Analyst and Chief Compliance Officer, Phillip J. Deerwester, advises investors that “setting an allocation and forgetting it forever is too passive.” He points out that even passive strategies need adjusting as investors’ time horizons and risk levels change.

With the median S&P 500 stock now much more expensive than in late 1999, and the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google/Alphabet) accounting for more than 100% of the S&P 500’s total upward move since 2015, risks are high.

Owning the S&P 500 Index is simple, cheap, and tax-efficient. It’s a reasonable, though not optimal, long-term portfolio strategy. It is never a low-risk strategy, and right now it looks pretty darn dangerous to us.

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by TGS Financial Advisors (“TGS”), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from TGS. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. TGS is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the TGS’ current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are a TGS client, please remember to contact TGS, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. TGS shall continue to rely on the accuracy of information that you have provided.

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