Thursday, January 1, 2015

Total Stock Market Index Funds: Neither Safe Nor Quality Investments

I was four months ahead of telling all of you something unique and insightful about a phenomenon we saw in 2014.  I'm talking about the massive, and I mean massive, movement of money from actively managed funds to passive index funds.  See, back in August of 2014, I wrote this post: Switched-to-index-fund-this-year-why....  I wasn't very nice with my headline, calling anyone who made this move a "cow."  I apologize for that.  However, I did it out of love and the need to educate you.

On 12/30/2014, MarketWatch's Opinion segment published this article: troubling-things-index-funds-wont-tell-you.

If you bought shares of the Vanguard Total Stock Market Index, like tons of people did in 2014, what was your motivation?

See the pattern above can only be explained by a large number of people believing in something misleadingly, qualifying the merit of an investment subjectively versus objectively.  At least three widely known factors contributed to the shift away from active to passive:

1) Advertisement (low fees was the selling point) by Index Fund vendors (Vanguard, Schwab, etc.)

2) Statistical evidence showing hedge fund and mutual fund managers underperforming the market.  Note although most underperformed, there were a handful that matched or beat the market.

3) A 5-year and counting bull market where "alpha" (stock picking prowess) took a back seat to "beta" (stocks moving up together for the most part).

Those three factors combined, in my estimation, changed the perception of the Total Stock Market Index Fund going from a price considered investment to an "at any price" one.  Indeed, this equity has gained traction in the mind of the unsophisticated investor as being of "quality" and "safe."  

Does the fact that so much money is indexed — a step taken in part because it’s thought to reduce risk — actually raise the odds that shareholders will face steeper losses in the next bear market than if they owned actively managed funds?  --How Index Fund Mislead Investors.

What's most lamentable is that many new Total Stock Market Index Fund investors entered their positions in 2014, buying shares of their mutual fund when prices where at their highest:

This flood of money into index funds came after the market already had recorded substantial gains. Stack contends that such lopsided affection for passive investing — and the lack of concern for risk that he infers from it — hints at an approaching top, as does the evidence of history.--How Index Fund Mislead Investors.

Being in a Total Stock Market Index fund does not afford an investor any protection when the stock market suffers severe losses.  The diversification in owning all of the market makes no difference.  In fact, since most total stock market index funds are capitalization weighted, owning in higher allocations the shares of the largest companies within the index, the fall would be exacerbated:

Index funds can also suffer from their emphasis on momentum over value. Benchmark indexes tend to be capitalization weighted; the highest allocations go to the market’s largest companies. As investors make big stocks, such as AppleAAPL, +0.00%  and Google GOOG, +0.00%  , bigger, the stocks become bigger parts of indexes, so when investment in index funds rises, even more money goes into those stocks, Stack points out.
Cheaper and more defensive stocks, by contrast, become even more ignored. The result is enhanced volatility, as ever-fewer stocks dominate market capitalization and trading volume. That can set up the market — and index funds — for a greater fall as investors abandon the momentum stocks that had become such major index constituents.--How Index Fund Mislead Investors.
What is an investor's biggest concern when investing in the stock market?
That's easy.  It's being wiped out, of course.  In the first nine months of 2014, $173 billion found its way into index funds, including monies going into Vanguard's Total Stock Market, now well past the $300 billion mark for sure (see graphic above).  Knowing how much money is being held in a fund is dangerous.  It gives new investors, again, the idea that there is strength in numbers.  If so many people are in this fund, then it must be of quality and it must be a safe investment, goes the thinking.
Let's consider a hypothetical scenario involving returns: sp-500-return-calculator/
  • December
  • 2008
  • December
  • 2014
X Adjust for Inflation (CPI)?
Total S&P 500 Price Return:
  • 108.27%
  • 13.007%
  • 135.270%
  • Yes

Even if the above calculations are wrong, just humor me for a second.  Say you invested, buying a $10K stake in Vanguard's TSM Index fund in December of 2008, and have been buying shares since then at will (or even in periodic monthly lots).  You've captured the returns above within the six year bull market run.  What if we enter correction territory in 2015 that starts a bear market of seven or eight or even ten years?  Are you the type of investor that will be able to persevere upon seeing your gains and invested capital erase year after year?  It took 15 years for U.S. equities to return to pre-stock market crash (1929) levels!  Most-important-risk-to-equity-investors.
How many of the millions of investors who have bought on the news and the momentum of the herd would be willing to continue to buy shares of their Total Stock Market Index fund as prices fell for 2, 3, 5, 7 years in a row without hitting the panic button and selling low?
How many of you have the patience to continue the course?
How many of you have the time frame to continue the course?


1) Having all of your money in a Total Stock Market mutual or exchange-traded fund is a recipe for disaster.  If you favor simplicity, you must add at least one or two more funds to your portfolio.  A Total Bond fund and a Total International Markets fund would work.  Then you have to concern yourself with re-balancing.  After all, your Total Stock Market fund has eaten like a king the last several years and is need of a diet...yup its gotten obese.  The weight of each asset class (stocks, bonds) must always be at your desired target allocations.  So sell some of your TSM IF shares until you're "healthy" again.

2) Consider investing in a Target Date fund, a fund-of-funds.  I've talked about these before in previous posts.  Main reason to do so is that they shift your stock/bond mix progressively over time, depending on your retirement date.  Nonetheless, they too come with risks.  You must make sure you know at all times what mutual funds the TD fund holds, and then individually look through each fund with a fine tooth comb. Is there overlap?  Also, are the fund managers sticking to their equity glide path (a fund's changing allocation from stocks to bonds over its expected lifetime)?  There are other considerations, e.g., costs and asset class selections.

3) Only bear the risks associated with having most, if not all of your money in U.S./International equities via indexing if you have a minimum of twenty years and buying shares is automatic, happening at least once a month.   And for God sakes, don't panic sell!

My index strategy for 2015 (if I were just starting out and had $10K to invest):

1) Buy a Europe index fund now when their equities market is where ours was in 2007-08.  My choice: Vanguard's FTSE Europe ETF (VGK).  Amount: $2500

2) Mitigate interest rate hike risk by buying a Bond ETF with shorter maturities such as ProShares Short 20+ Year Treasury ETF (TBF).  You'll be getting a low yield to start but once The Fed starts raising rates, the performance of the fund will improve.  Amount: $1500

3) Buy Vanguard's Total Stock Market ETF (VTI).  Yes, even though it is incredibly expensive right now.  I'd wait for a sell-off, however.  One is bound to happen in January.  Amount: $1000

4) Cash.  Remaining amount: $5000.  With this cash I'd buy in $500 blocks only when I was 3 or more % below my cost basis on any of these three investments.

As always consider all of your decisions fully before doing any investing.  And only invest with money you can afford to lose.  
Thanks for reading!  Have a great year.  Don't forget to subscribe to this blog, tell others about it, and support your amigo, Carlos out! 

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