The Shocking Truth About Index Funds

Conventional wisdom says that index funds are the place to be, at least for most individual investors.

Markets are (mostly) efficient. Little guys have almost no chance of beating the pros at picking stocks. So why not just stay away from individual stocks altogether and put everything in an index fund?

What’s In An Index Fund?

Many people regard index funds as prudent, reliable, trustworthy friends who work tirelessly to safeguard your savings and fund your retirement. Those same people view individual stocks as dangerous renegades who will drink your beer, steal your money, and run off with your spouse.

But I have some shocking news, and index lovers may want to brace themselves.

Do you know what makes up an equity-based index fund? Individual stocks! Those same scoundrels, who aren’t worth a dollar of investment on their own, can suddenly form a mob and become a respected and heralded investment option.

How does that happen? It must be that index creators use super secret, proprietary screens to ensure only the very best companies get in. And good luck finding out what those companies are, right? The list of index member companies is surely a closely guarded secret.

Actually, no on both counts. Index publishers will let almost anyone in – many of them do little more than rank companies by market capitalization and take a portion of that list. The index isn’t trying to pick sure winners, it’s just trying to be an objective measure of part or all of the stock market. And the index makeup is normally widely publicized, making it easy to find out all of the component companies.

In the ultimate DIY experiment, you could therefore build your own index fund. You could pick an index that you like, but rather than buying an ETF or mutual fund that tracks it, you could buy the stocks of all the individual companies according to their index weight.

Granted, that would be an administrative challenge, and if you had a small portfolio, the trading commissions (e.g., 500+ trading commissions to replicate the S&P 500) would be prohibitively expensive. You would also have to follow the index and adjust your holdings when the index changed. But it could be done, and that alone highlights an important point: Indexing versus individual stocks isn’t a black-and-white affair; it’s all shades of gray.

The value of indexing is that a single trade can get you the basket of stocks, and the fund company will change holdings with the index so you don’t have to worry about it. That’s a valuable service, but it’s not priceless. A multi-millionaire could get similar results by directly investing in the index component companies.

Chasing Diversification

One of the greatest advantages cited for index funds is the diversification they provide.

The argument is that it’s very hard to fully diversify all of the diversifiable risk with individual stock holdings (try saying that 10 times…), but it’s easy to do with a single index fund trade.

The S&P 500 is a very popular index, and it is based on 500 of the largest companies on the NYSE or NASDAQ. However, each company doesn’t have a 1/500 (.2%) weight in the index. It is a “market-cap” weighted index, meaning stocks with higher market capitalizations are weighted more heavily. Its current top holdings are:

• Apple Inc (AAPL)
• Microsoft Corp (MSFT)
• Amazon.com Inc (AMZN)
• Facebook Inc A (FB)
• JPMorgan Chase & Co (JPM)
• Berkshire Hathaway Inc B (BRK.B)
• Exxon Mobil Corp (XOM)
• Johnson & Johnson (JNJ)
• Alphabet Inc C (GOOG)
• Alphabet Inc A (GOOGL)

As of today, these 10 stocks make up ~20% of the entire S&P 500 index (Apple alone is just under 4%), while the lowest market cap company in the S&P 500 barely contributes anything to the index. If you invest in an S&P 500 fund and think you have extremely broad coverage across 500 stocks, you might be surprised at each individual company’s weight.

In addition, the market cap weighting means you can get a concentration in certain industries when they’re hot. The current top 10 holdings show a heavy bias towards tech. That’s not a bad thing, since it just reflects those companies have been key drivers of the nice run the S&P 500 has had. But if I were building a stock portfolio from scratch, I wouldn’t want those 10 companies to be my largest positions.

The key to diversification is correlation (how much things tend to move together); if two stocks are highly correlated, holding them both doesn’t diversify your portfolio as much as if they had a low, or even negative, correlation.

You can build a well-diversified portfolio with far less than 500 different stocks, especially if you avoided over-concentrating in any industry (e.g., tech) and if you made equal investments in a diverse group of companies rather than weighting your investments by the company’s market capitalization. Indexing isn’t the only option for diversification.

My son loves breakfast sausages, but I think he would have grave concerns if he knew what the sausages actually contain. I fear sometimes that index investors are the same. Folks who are totally fearless and cavalier about indexing might blanch when you showed them the component companies they actually own.

I’m sure much of the appeal of indexing comes from not having to understand what’s actually in the index (“Just let us enjoy our delicious sausage!”). However, even a cursory understanding of index fund components can help reduce risk, increase returns, or both.

Weighting Matters

The purpose of an index isn’t necessarily to identify the best investment opportunities; rather, it’s to be a somewhat objective measure of what’s going on in the stock market (or a portion thereof).

For that reason, weighting the index by market capitalization does make sense; the fortunes of Apple are certainly far more important to the overall market and economy than those of Signet Jewelers Limited (SIG – one of the smallest components of the S&P 500).

However, by taking large cap companies (along with screens for profitability, liquidity, etc.) and then weighting the index by market cap, the S&P 500 and other large cap indexes may be limiting investment opportunities. I often view large cap indexes as containing many “already winners” and “to-be losers”. The components – especially those with the greatest weight – are often wonderful, successful, profitable, market-leading companies, but they may not be quite as wonderful investments.

For my own portfolio, I prefer significant exposure to small cap stocks. Small caps may be riskier than large caps, but I always remind myself that I’m investing in the stock market. Risk, and the returns that will hopefully accompany it, is kinda why I’m here.

Small cap exposure can certainly come from a small-cap index fund, but those funds seem to be far less popular. Rather, many investors I know believe they’re getting small cap exposure from a “Total Market” index. Technically, that’s true, because total market indexes include small caps, but the small caps are in the long tail that is crowded out by the much larger companies. A small cap’s weight is almost nothing when it’s standing next to Apple.

Components and weighting definitely matter. If you think you’re going to get really diversified by investing in three different funds (say, a U.S. large cap, U.S. total market, and global total market index), you might be a bit shocked at how much overlap there is between the three (hint: the largest holding in each one would be Apple…).

Understanding the components and weighting of index fund investments is therefore critical. For instance, if I put half of my money in a large cap index and half of it in a small cap index, that is a very different portfolio than if I put all of my money in a total market index which contains the same companies (but not weights) of the large and small cap indexes.

The Real Benefits of Indexing

An index isn’t a group of guaranteed winning stocks. It’s just a bunch of stocks. Some are great. Some are good. Some are terrible (remember Enron?).

I don’t believe that indexing is a brilliant investing strategy; rather, it’s protection against a bunch of terrible investing strategies. Investing in a broad-based index fund prevents you from:

• Over-concentrating in any one company or industry
• Chasing the herd (because you are the herd)
• Common biases and mental accounting mistakes, like selling winners too early, doubling (or tripling, or quadrupling) down on losers, chasing hot companies, or ignoring cold ones
• Missing out on the stock market as a whole

You could avoid all of those mistakes yourself, but it would take some experience and a lot of discipline. Index investing is simply a form of outsourcing that provides those protections at a reasonable price.

As with any outsourced service, it’s good to have a basic understanding of what you’re buying, even if you don’t understand all of the details. While it’s easy to treat an index fund like a black box, understanding “how the sausage is made” and what’s actually in index fund investments (especially across funds) can maximize the value that indexing provides.

I am a huge fan of indexing and the philosophy it represents. Index funds are one of the best investment options for most individual investors, and although a majority of my holdings are in individual stocks, I definitely use an “index mindset” in my investing.

In fact, the only thing keeping me from putting all of my money in index funds are some distinct advantages that come from owning individual stocks. And guess what’s the subject of my very next post? 🙂