When Scotts Valley Market lowers the price of ice cream, shoppers will buy more ice cream. When the price is raised, shoppers buy less.
That’s how it works in most parts of the economy, but not in the stock market – especially nowadays, as passively managed index funds have become overwhelmingly popular.
An index fund is a mutual fund or exchange-traded fund (ETF) that aims to replicate the movements of an index, like the Standard & Poor’s 500, which is composed of the 500 largest U.S. companies. Index funds now account for 31-percent of fund assets, up from 14-percent in 2004.
Two factors have caused this popularity:
Low cost: Essentially, an index fund is managed by a computer. This is much less expensive than paying a professional manager to research companies and seek out growth and value, as actively managed funds do. Fees for passively managed funds are just 0.2-percent per year compared with 0.79-percent for actively managed funds, according to Morningstar.
Better performance: Index funds have provided better investment results recently. Over five years up to the end of last year, 88.7-percent of fund managers investing in large companies underperformed the S&P 500.
So, what’s the problem?
My goal has always been to buy low and sell high. But that’s exactly the opposite of what index funds do.
Index funds are “market capitalization weighted.” Market capitalization is the total value of the shares outstanding. If a company has 1 million shares outstanding and its shares sell for $10 each, then its market cap is $10 million.
The bigger a company’s market cap, the more weighting that company has in an index. The more a company’s stock price goes up, the more shares of that stock an index fund has to buy. Stocks that go down in price see their market cap drop, so index funds have to reduce their weighting.
In other words, index funds are required to buy high and sell low.
The strategy has been working as more investors and advisors accept the idea that index investing is superior to actively managed funds or individual stock picking. The stampede of money into index funds drives them higher as they bid up the prices of a narrow group of richly valued companies.
Instead of tried-and-true method of investing in companies with stock prices that are low relative to their current or expected profits, index funds invest in stocks simply because they have been going up.
“When you buy index funds, you’re looking to the future through a rearview mirror,” said legendary investor Leon Cooperman last month on the TV show “Wall Street Week.”
I’m not opposed to index funds, and many of my clients own them. They offer diversification for low fees. But low fees do not necessarily equal low cost. If a fund is buying stocks at inflated prices, then it’s not really a low-cost investment, even if the management fees are low.
Maybe index funds will continue to outperform other investment strategies. But my experience has been that when a trend continues for years and gets too popular, and everyone accepts that what is happening now is the way it will always be, it’s time to think about alternate strategies.
Mark Rosenberg is a financial adviser with Financial West Group in Scotts Valley, a member of FINRA and SIPC. He can be reached at 831-439-9910 or [email protected].
