The Dark Side of Index Funds

Index funds have taken over the world of investing. If you don’t count GameStop, AMC Theaters and Tesla, index funds are the most talked-about investments today. Bogleheads and Housel readers alike all flock to this asset as the godsend of investing. This almost makes it seem like you can do no wrong here. Doesn’t this sound a little fishy? How can one asset be the end-all-be-all to investing? 

Everyone talks about the upsides of index investing. But what about the downsides?

The Basics of Index Investing

The health and return of the stock market are measured by indexes. Many stocks are grouped together and their performance is averaged out. Each contains a different range of stocks in the index. The Dow Jones Industrial Average includes only 30 while total market indexes can include thousands of different stocks. The most popular is the S&P 500. This index, as you may have guessed, contains 500 of the largest stocks in the U.S. stock market.

An index fund trades like a stock, and it tracks these market indexes. If you wanted to get the same return as the market, you could buy all 500 stocks of the S&P 500, or you could simply buy the index fund. The index fund will automatically invest your money in all 500 stocks at once.  

The Upsides of Index Investing

Even though index funds were invented in 1975, their popularity has skyrocketed in recent years. They offer a low-cost way for people to hire their own investment advisor. Recent studies have shown that passive investing–read: index funds–outperform many professional active investors. They also free up the investor’s headspace. When you invest in index funds, you no longer have to worry about what specific stocks are going to do.  

For many people, index investing is the best strategy, and I’m a big fan. I keep a large chunk of my investment portfolio in index funds.

That doesn’t mean they are without limitations.

Digging Deeper

When you purchase an index fund, you don’t actually purchase the stocks themselves. You own a product that closely tracks an index.

In other words, you own an asset that mimics an asset. It has no intrinsic value itself.  

Let me explain. When a company creates an index fund, it must own the underlying stocks of that index. Take the SPDR S&P 500 Trust (SPY) for example. If you buy shares of this index fund, you only buy one asset–SPY. The company that creates that index fund–SPDR–must own all of the stocks in the S&P 500. This acts as a sort of collateral.

Photo by Alec Favale on Unsplash

This also means that you don’t own anything when you buy an index. When you purchase a stock, you receive voting rights as well. This is the investor’s opportunity to affect the future of the company. But when you own an index, you don’t really own the stock. The company that created the index does.

The company that created the index owns the real assets. When you buy into an index fund, you choose to delegate your power to large financial firms. Your index fund has value because these financial institutions give it value.

Every Up Has Its Down

Index funds have been brilliantly marketed. They are made out to be the end all be all to investing. People are quick to jump to the aid of Jack Bogle. They claim that Jack invented the index fund for the betterment of society. Index funds would be the average investor’s key to competing with the big dogs.  

But people forget that he was the CEO and founder of Vanguard–one of the largest brokerages today–and index funds are their largest product. Every time money is put into a Vanguard index fund, the company profits. Most of the trades done within the Vanguard funds are automated. Once they cover their fixed costs, it’s nothing but cash in their pockets.

That doesn’t make Jack Bogle a bad person. It makes him a good businessman. He provided a great product for millions of people to better their lives and certainly improved the world.

Just remember that his company benefits from index funds just as much as you do–if not more.

Conclusion

After reading this you might say that I’m cynical about index funds.

Well actually, I love index funds! They have provided a way for novice investors to get a piece of the action with fees close to zero. Over 1/3 of my net worth is invested in index funds. Index funds, for me, provide diversification to my strategy. Even if my philosophy doesn’t pan out like I thought it would, at least some of my money is earning the market return.  

I also believe in investing according to your convictions. When you invest in index funds, you don’t get to pick the stocks you buy. If there’s an underperforming stock or a company you don’t support in the index, tough luck. You have exposure to them anyway.

Moral of the story: when someone pitches you a product that has no downsides, be skeptical. Do your research and try to see the big picture.

Thanks for reading!

Featured photo source: Chris Liverani on Unsplash

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4 thoughts on “The Dark Side of Index Funds”

  1. Umm vanguard the company is owned by its underlying funds. So cash in their pockets accrues to the funds. That’s the unique part of vanguard versus the other providers of index funds or brokerage houses. It’s essentially a coop. There are downsides to index funds from voting and from things like lack of control over securities lending or lack of granularity. On that part I agree.

    1. Lack of control is the biggest part. By putting your money into a fund, especially one as large as Vanguard, investors are these companies an enormous amount of power. This is the case for all investment management firms.

      Vanguard’s unique structure doesn’t mean much in the long run. Fund “owners” own stock in Vanguard that can’t be traded on the open market, so it has no liquid value.

      Vanguard employs 18,000 people and a previous CEO notably made $15 million one year. There are plenty of pockets for investment returns to flow into that aren’t shareholders.

  2. Index funds aren’t the be-all, end-all, but they are a great candidate to make up a large portion of many investors’ portfolios.

    A couple of corrections (in addition to the one addressed above about Vanguard’s ownership structure): The S&P 500 is not the 500 largest US stocks. Inclusion in the index has several criteria, and size in one of them. In essence, it’s actively managed. See Tesla’s recent inclusion.

    Also, there are larger indices than the Russel 2000. The CRSP US Total Market Index, which is mirrored by Vanguard’s VTSAX & VTI, has over 3,600 publicly traded US stocks.

    You’re onto something with the potential downsides, but you’ve got some research to do and corrections to make to the post above.

    Best,
    -PoF

    1. Thank you for providing more clarity to the market indexes. There certainly are nuances to this that could be an article of its own. I updated that paragraph to make this more clear.

      I’m well aware of the Vanguard structure, and, as I included in a previous comment, that makes little difference in the grand scheme of this article. When Vanguard collects its fees, a large portion is paid out to the people within the organization (“cash in their pockets”). Since they are not publicly owned, it’s impossible to say how much this is, but reports from 2015 show that a previous CEO made $15 million one year. I’m sure he’s not the only one receiving a large paycheck. And even though the clients are the owners, they hold no voting power. This power lies in the hands of the Vanguard Investment Stewardship team and externally managed funds.

      I’ve done extensive research on the matter, and as far as I am aware, I am presenting no misinformation on the subject. If there is something specific that is incorrectly stated, please let me know and I will be happy to correct it.

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