Why Index Funds are Bad Investments

The entire personal finance blogosphere is in love with index funds, and I’m here to tell you why they’re bad for your investment portfolio.

This should go over well.  Black sheep anyone?

I realize this thesis will not be a popular one, but from my perspective as an active investor and stock picker, I’m here to tell you that index funds have essentially been dead money for the last decade.

So why do bloggers constantly recommend index funds?

  1. Index funds are very easy to understand.
  2. They likely know little to nothing about the stock market.
  3. They don’t want to recommend individual stocks or mutual funds for fear of reprisals.
  4. It’s an easy answer to a difficult question because index funds require little to no research whatsoever.
  5. Everyone recommends them, so they feel safe passing along the same recommendation as the rest of the herd.  So if the market tanks, they got fooled like everyone else and everyone likes to fit in.

Pretty tough critique of my comrades to say the least, but I think that is a fair assessment.

Naturally, everyone will say “Why are you speaking such blasphemy about our beloved index funds?“  Easy.  Pull the stock charts and check the research my friends!

Below is a very simple overlay chart of the S&P 500 (the most popular stock index to track) compared to the CGM Focus Fund managed by Ken Heebner, who was voted Morningstar’s Top Fund Manager of 2007.  Just give that chart a few seconds to soak in.

Heebner’s CGM Focus Fund is up 320% in the last decade compared to the S&P’s lackluster 25%.  Shocking isn’t it?

Take note that the S&P 500 index fund did not return 25% each year, but only 25% in the last decade.  Considering that gas prices have doubled (maybe more) and food inflation has skyrocketed in 2008 alone, it’s a plausible argument that a 25% return over 10 years won’t keep pace with your spending requirements in later life.

I expect better for my money, and so should you!

Now, depending when you began purchasing shares of the S&P 500 index fund (one lump sum purchase or a consistent dollar cost averaging purchase plan), you would almost certainly have a different outcome.  For example, if you began accumulating shares 2003, you could be up as much as 50% for those particular purchases.  A very respectable return.

Conversely, had you made a single lump sum purchase in mid 2000, you still have a net loss 8 years later.

The major point being, if you purchased shares from 1998 to 2008 on a consistent dollar cost averaging basis, you would see very little, if any realized profits on your total balance.  You may even have a negative return once the full numbers are calculated!

If you have spent any significant time researching the stock market over the last decade, or you just enjoy reading personal finance blogs, you have ostensibly found that index funds have become the core holding in the so called “lazy man’s portfolio“.

To put it simply, an index fund investor is essentially buying a very diversified group of stocks all lumped into a nice, neat, no nonsense package with very low expense ratios.

However, like any diversified object, you often get the slackers in addition to the high performers.

Take for example, your high school graduating class.  You had the brainiacs taking AP Calculus on one end of the spectrum, but you also had the kids who barely graduated.  By basic bell curve statistics, you are left with a large group of average performers pulling a 2.0 grade point average.

Same thing with buying basic index funds – you get some good, some bad, but mostly average performing stocks.

That’s fine if you want to want to travel within the safe confines of the herd and make average returns based upon broad market sentiment and the economic outlook of the U.S. Stock Market (or global economy if you buy foreign index funds), but considering the overlay chart above… do you really think that index funds are your best option?

Probably not.

How do I make my money work harder?

  1. Pick mutual funds with an excellent track record of out performing the S&P 500.  Any website like Morningstar, Kiplinger’s, or blogs like mine will always cover the better performing mutual funds and exchange traded funds (ETFs).
  2. Setup an account with a full service brokerage firm.  These are more expensive, but like anything, you get what you pay for.
  3. Hire a financial planner.  If you are looking for more better than average returns, let him/her know your goals and it’s just that simple.
  4. Ask for advice from a trusted colleague/friend with investment experience. I learned how to invest from a family friend, and it’s one of the best financial moves I ever made.
  5. Do it yourself and build your own mutual fund. There are many websites and blogs that cover mutual funds or individual stock research, so grab a few RSS feeds, do your own research, and away you go.  Just make sure you know what you’re doing, and start small in the beginning.

Now, tell me honestly, can you make a case why your diversified index funds can hold a candle to professionally managed mutual funds with an excellent fund manager who has consistently outperformed the broad market?

  1. High expense ratios. True, costs will eat into profits but when you have a fund outperforming the broad markets, you are getting what you pay for.
  2. No Load mutual funds. I would never buy a load containing mutual fund, and anyone who does is throwing away money.  They are a horrible remnant of old world investing, so avoid them at all costs.
  3. Automated investing. Almost any mutual fund has an automatic investing plan available.
  4. Less risk. It’s true that some mutual funds can be risky investments, but that is where your own research comes into play or that of your investment adviser.

To sum it all up, I’m not suggesting that index funds are horrible investment choices and should immediately be sold if you own them.  Not at all, because I own index funds in my own retirement accounts.

I’m merely pointing out that you shouldn’t close off the possibility of owning several traditional mutual funds or ETFs that have superior historical returns.  By allocating a certain percentage of your overall portfolio to higher risk investments, your returns could potentially be far better than using index funds only.

Who knows?  Perhaps one day in the future, you might actually be able to buy one of those $4 coffees without all that self loathing, self indulgent guilt!