The Inherent Risk of an Index Fund
There’s always a latest rage in investing. This is ironic because in actual practice, investing is boring. Investing means reading quarterly reports. Investing means pouring over numbers to decide if a company is worth owning. Investing is not exciting.
Yet there are such things as “investment crazes”. The tech boom was one. Millionaires were made over night. High schoolers were successful investing, so their parents gave them their college fund to invest. Then April 2000 came and went. And so did trillions of dollars invested in over-priced stocks and worthless dot-com’s.
I read this guy and agree that agree that Index and ETF’s are the next fad. They’re not necessarily poor investments. They’re just not the end-all, be-all that they’re advertised to be. And because they’re popular, they’re open to abuse from those who want to take our money.
Basically an index fund is a mutual fund that does nothing but buy the stocks (or bonds) in an index that is widely tracked. They have cheap Management Expense Ratios (MER’s). They consistently beat most other actively run mutual funds because they have low trading costs, no research costs, and thus are more likely to beat mediocre to poor active fund managers. Index funds beat 75% of actively managed mutual funds. I’m not suggesting you don’t consider them. They’re great.
The problem is that a sector index fund doesn’t have to be “widely-tracked” or even “diversified”. Investing in the TSX300 index (back in 2000) meant that 30% of the index was in Nortel. When it shot up to $127/share the index sky-rocketed. When NT dropped to $0.67 it took the index with it. There are all sorts of indices to track. The iShares tech index XIT used to be 25% Research in Motion (RIM), 25% Nortel (NT) and the rest in other tech companies. Buying the index fund in this case is neither diversified nor wise.
Exchange Trade Funds (which often track indices) create several problems. Yes, you can buy them in a heart beat. And you can sell them equally quick. The problem is a) you get nailed for a commission from your broker and b) being so saleable means you won’t think twice when the market looks uncertain. Buying and holding is harder when its so liquid without the proper discipline that I don’t have.
Because index funds and ETF’s are so popular, expect lots of “selection” from the mutual fund companies. They’ll sell you an exchange traded index fund that tracks the number of turkeys in Kentucky. They’ll rename their mutual fund just to call it an index fund. People will blindly buy an index fund because the media is calling it the next sure thing. Everyone pours their money into them, it’s logical with facts from 80 years to back up the arguments for them and suddenly every stock in the i60 is priced twice as expensive as everything else. Sooner or later the expected growth of the stocks dwindles to zero and pensions liquidate, leaving private investors in the lurch.
That’s you and me.
I have index funds. They are cheap. They beat active managers 75% of the time. Just don’t buy an index that doesn’t have 300+ stocks. And avoid specific sectors. Hedge your bets. If you put money on every number, unlike roulette you’ll actually fare better than most.
Happy hunting.
on February 3, 2010 at 7:02:pm
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Hi Joel, thanks for the mentioning and reading my blog. I hope you found it informative, and am glad you can see the advantages, but also the limitations of index funds / ETFs. Its good too see another Canadian investor, giving things considerable thought, rather than blindly following the herd. Keep it up the great work and happy investing!