Index Funds: Criticisms and Comments

The JofA received a number of letters regarding the two index fund articles that ran in the January 2000 issue. These included letters from readers who pointed out errors in one of the articles as well as readers who took issue with some of the statements the authors made regarding index fund investing. Here is a sampling of positions taken. The author’s reply follows the last letter on this subject, page 92.

I could not believe the article “Inscrutable Index Funds” ( JofA , Jan.00, page 24) was presented as fact. In addition to certain factual errors, it contained more subtle misrepresentations.

On page 31 in the paragraph beginning “Lack of sell discipline,” the authors contend that actively managed mutual funds increase shareholder returns by selling stocks when they appear ripe to sell. If we call a spade a spade, this essentially says that mutual fund managers can successfully time the market—that is, pull money out when it is high and reinvest money when it is low. Only the most naive investor believes fund managers consistently succeed at this.

On page 25, the authors say the S&P 500 has consistently outperformed active managers from 1995 to 1998. While that statement is undeniably true, an uninformed reader might assume that prior to 1995, actively managed funds outperformed the S&P 500. Nothing could be further from the truth. From 1982 to 1998 the S&P 500 was in the top 50% of all general equity mutual funds 13 years out of the 17-year period. My source for this was the Vanguard S&P 500 annual report, confirmed by searching the Morningstar mutual fund service. For several of those 17 years, the S&P 500 was in the top 25% or better.

I am very disappointed in the JofA for allowing a slanted opinion piece like this to be presented as a factual article. My respect for the publication would be increased by some retraction or explanation.

Charles E. Schneider, CPA
Minneapolis

I ’m a bit confused about the information shown in exhibit 4, “S&P 500 Composition by Capitalization,” of “Inscrutable Index Funds.”

I am guessing that the chart, the source of which is shown as Invesco, is mislabeled. The chart title and the accompanying information claim that 90% of the investments of an S&P 500 index fund are in 10, mostly tech, companies. This is incorrect. I believe the chart actually shows the percentage of the S&P 500’s return attributable to the 10 stocks over a relatively short period of recent time.

I hope JofA readers are knowledgeable enough about the S&P 500 index to disregard this incorrect information. For those less familiar with the specifics of this index, who may be tempted to change their investments partly based on the article, it’s important to clear up some very misleading information.

Judy Shonborn, CPA
Greenfield,Wisconsin

While there are truly good arguments to make against the S&P 500, how “Inscrutable Index Funds” became the cover story of the JofA I will never understand. In fact, I’m not sure how it passed editorial review.

The suggestion that index funds are momentum plays because the funds indiscriminately buy larger positions in stocks of companies that are larger in size is incorrect. Index funds actually reduce the volatility of individual stock prices (vs. traditional active management) because they spread new investor monies around the stock market proportionately. Rather than throwing disproportionately large slugs of cash at small companies, which can easily alter market pricing, the funds are egalitarian, adding to individual stocks on a relative market-value basis. Thus, one would expect relative market caps to stay constant.

There is truth in the idea that new cash coming into the market can cause market momentum. That’s why investors often look at trends in cash coming into or out of the marketplace. However, this is a macro issue unrelated to index investing.

Following the notion that index funds cause momentum stock buying, the article suggests that one should cut back or “rebalance” from winners to other, presumably, less winning names. Not only does this ignore the premise of long-term investing and the logic of keeping the relative values within a portfolio constant, it calls for the triggering of otherwise nicely deferred taxes. Paying tax with investment proceeds that could otherwise be compounding tax-free is a basic no-no that should be avoided.

To dispel any notion that I am an index fund groupie, I would like to offer what I believe are potential shortcomings of S&P 500 index funds:

• The S&P 500 is incomplete and/or behind the times. While stocks in the index are chosen by Standard and Poor to reflect broad economic currents flowing through the economy, some major names, especially in up-and-coming sectors, are absent from its ranks.
• Tax inefficiency. Many investors rightly diversify, owning mid-cap S&P 400 and large-cap S&P 500 indexes. The reality is that tax efficiency is lost when one begins segmenting groups of indexed equities, because growing companies are sold out of the S&P 400 mid-cap index with taxes paid on gains and then repurchased into the S&P 500 large cap index with bid-ask spreads and trading fees also incurred.
• Delay in reacting to changing market composition is also potentially costly to investors or at least creates tracking errors to the true “theoretical market basket.” One example is initial public offerings (IPOs). The S&P makes no attempt to recognize IPOs when they occur, instead choosing to wait for some arbitrary future point to include large new public companies.

Darren A. Bramen
Newtown Square, Pennsylvania

I enjoyed “Inscrutable Index Funds.” It raises some valuable issues. However, there is a factual error and I have some minor quibbles.

Error: The composition of the S&P 500 index is no longer the 400/40/40/20 mix the article describes. These constraints existed prior to the mid-1980s, but no longer. For example, instead of the 40 financial stocks indicated, there are currently 71.

Quibbles: It is somewhat disingenuous to claim that “hidden dangers lurk” in passive investing. While this may be true, a poor match between investment policy and investment vehicles is a danger of any investment, not just index funds.

The sidebar (page 27) about fiduciary responsibility seems narrowly focused on advisers to nonprofits. As CPAs provide investment advisory services to any client, they should realize they are acting as fiduciaries, whether the law specifies this or not.

The authors’ momentum investing argument is too strong. While it’s true that capitalization-weighted indices inherently “up-weight” recent winners, index funds also benefited from the upswing. True momentum investors would chase recent winners. Index funds accept market capitalization as a measure of a company’s relative worth; true momentum investors look to changes in price or capitalization as a measure of a company’s future prospects.

There is little evidence that actively managed portfolios successfully overcome the negatives you attribute to index funds: Contrarian strategies do not consistently beat momentum. More (or less) diversified portfolios do not inherently beat the index benchmark consistently. Whether growth dominates value is an open question. Sell discipline and down-market performance do not necessarily cause active funds to beat indices.

The second index funds article, “The Quest to Outperform” ( JofA , Jan.00, page 32) addresses some of these issues. The two articles form a nice package. Each adds invaluably to CPAs’ discourse on investments.

William W. Jennings, CPA, PhD, CFA
Colorado Springs, Colorado

F or those interested in the benefits of passive investing (see “Inscrutable Index Funds”), it is worth pointing out another passively managed alternative to index mutual funds.

Exchange-traded index tracking stocks (commonly known as Spiders, Diamonds and Webs) can provide investors with low cost, diversified exposure to a number of popular domestic and international indices or market sectors. These investments have advantages over index mutual funds in that they can be traded like stocks (priced and traded intraday, sold short or purchased on margin), have low purchase minimums and, most important, put investors in control of their tax exposure.

From a portfolio strategy perspective, the index tracking stocks available today allow investors more flexibility than index funds to build balanced portfolios around their own individual circumstances and objectives. For instance, investors may want to hedge or offset a particular exposure, such as a large holding in their company’s stock, by maintaining nonindex weightings in particular sectors.

Because of the market’s rapid acceptance of index tracking stocks, it is likely investors will have more such options to consider in the future.

Timothy C. Burns, CPA, CFA
CIGNA Investment Management
Hartford, Connecticut

The authors respond to readers’ comments:

Many readers recognized that exhibit 4, the pie chart on page 31, was labeled incorrectly. We apologize for this error. The chart, in fact, describes the degree of contribution the 10 largest stocks made to the total return of the S&P 500 index for the 9 months ending September 30, 1999. As of that date, those 10 stocks, which represented 2% of the 500 issues in the index, provided about 20% of the index’s market value.

The exhibit on page 25, “Sample S&P 500 Index Fund Returns,” was also incorrect in showing two different periods of time for comparison, thereby omitting Vanguard’s higher rate of return (16.672%). We apologize to readers and to Vanguard for this error.

Passive vs. active investment was the area of greatest feedback from readers. Our probing into the nature of passive investments should not be interpreted as veiled advocacy of market timing—rather, our goal was to alert readers to the risks inherent in a philosophy that does not employ the tools of fundamental analysis.

We agree the sidebar on fiduciary responsibility was too narrowly focused on tax-exempt organizations. A CPA who provides investment advisory services to any client, in fact, must exercise fiduciary responsibility.

We thank the readers who appreciated our article collectively with “The Quest to Outperform” as point and counterpoint on index fund investing. It was the JofA’s intent to contribute to CPAs’ discourse on investment topics.

Mark Johnson, CIMA
Laura A. Collins, CPA
Greensboro, North Carolina