What’s Wrong with Index Funds?

There are three issues that I have with index funds, and that’s why I don’t invest in them. 

But first let’s make sure you know what an index fund is.

What is an index fund?
An index fund is a mutual fund that pools money from lots of investors like yourself, and then invests that money on your behalf into stocks. A typical mutual fund has a fund manager who decides which stocks to buy and sell. However an index fund has no live fund manager, the fund manager is a computer that buys stocks from a list (an index). For example the S&P 500 Index is a list of 500 US companies, a S&P 500 Index Mutual Fund will only invest in those 500 companies. If a company is removed from the list, the index fund will immediately sell those shares and buy shares in a new company which has been added to the list.

Index funds buy stocks at high prices
Everyone has heard the phrase “buy low, and sell high”. It makes sense that you should buy stocks at a low price (when they are undervalued). Why would you pay $89 for a stock when you could buy it at $23? Watch my short video which shows you how to figure out if a stock is undervalued or overvalued.  You want to avoid buying stocks when they are priced high. But with an index fund you have no choice but to buy some stocks when they are priced high. A US Index Fund may contain 500 stocks in its list, on any given day (especially the day you buy the index fund) some stocks in that list will be undervalued and some will be overvalued. I only buy stocks when they are undervalued, anything else would be foolish.

Index funds buy lousy stocks
Take a look at both companies below, which one would you invest in?

Company A

• Stock is undervalued
• Debt is 12%
• 10 years of consecutively increasing earnings (profitable)
• 10 years of consecutively increasing dividends (money paid to shareholders)
• Credit rating of AAA

Company B

• Stock is overvalued
• Debt is 187%
• 4 years of consecutively decreasing earnings (not profitable)
• Company pays no dividends (money paid to shareholders)
• Credit rating of CCC

As you can clearly see all other things considered equal, Company A is a much better investment. In other words Company A is a quality company. You want to avoid buying non-quality stocks. But with an index fund you have no choice but to buy some stocks of inferior quality. A US Index Fund may contain 500 stocks in its list, on any given day some stocks in that list will be quality stocks and some will be lousy stocks. I only buy quality stocks, anything else would be foolish. I follow my 12 Rules of Simply Investing to help me determine if a stock is a quality stock.

You’re still paying fees
Fees are much lower for index funds than managed mutual funds, but a fee is still a fee. Using an online calculator I compared the cost of owning an index fund versus owning individual stocks:

Index Fund A

• Amount invested: $100,000
• Index Fund Fee: 0.35%
• Index Fund: TD US Index Fund-e
• Total fees paid after 25 years: $27,859.54

Index Fund B

• Amount invested: $100,000
• Index Fund Fee: 0.08%
• Index Fund: Vanguard Value Index (VVIAX)
• Total fees paid after 25 years: $2,000.80

Individual Stocks

• Amount invested: $100,000
• Trading Fee: $9.99 per  trade
• Number of stocks held: 20
• Total fees paid after 25 years: $199.80

The Vanguard index fund certainly has lower fees, but keep in mind that's $2,000 for every $100K you have invested. For a $500K portfolio the fees go up to $10,004. Plus you end up paying those fees each year for as long as you continue to hold those funds. With individual stocks you pay $9.99 per trade when you buy and then another $9.99 per trade when you decide to sell. I think you'll agree that $199.80 is much less than paying $2,000.

Index investors will argue that they get better diversification than owning individual stocks, but the truth is they are over diversified. As we’ve seen from above the more stocks you own the higher the chances these stocks will be overvalued and of inferior quality. I've written about diversification and risk here.

Index investors will then argue that it takes too much time to research individual stocks, but the truth is using my Simply Investing Report is faster than researching the 1000’s of index funds out there.

What if you have absolutely no interest in investing by yourself? Then the indexing strategy might be for you, but then you must also be content with lower returns and higher fees.....more than 28% of your investment will be lost to fees.

Save on fees, and buy quality stocks when they are undervalued. It’s that simple, even easier than indexing.

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