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.
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.
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.
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!