The first is that there is a lot of turnover every single year, which is not good for wealth building. In fact, the turnover is approximately 3% – 5% per year on average. This means that every year anywhere between 15 and more than 25 companies are added and replaced by the benchmark, incurring fees for the investor. Buying and selling of stocks is the reason many investors underperform their benchmarks.
For indexes like S&P 500, this frequency of asset turnover has lead to underperforming a purely passive portfolio of stocks. Did you know that the original 500 stocks of S&P 500 from 1957 outperformed the S&P 500 index by 1% point for 50 years? My previous article on the topic discusses research done to prove this.
The second flaw is that index funds are weighted based on float and market capitalization. This is to serve the mutual fund industry, not the investor. If you are a big shot mutual fund, and you want to raise $100 billion from investors, you cannot follow a passive strategy that requires you to put money equally between 500 companies, because for some the total amount of stock available to purchase might be less than $200 million.
Therefore, some companies are ignored, at the expense of focusing on the biggest. In reality, the equal weighted S&P 500 has done better than the market cap weighted S&P 500 over the past decade.
The third flaw is that I do not know what criteria the index committee uses to include stocks in the S&P 500. Sometimes, they (just like any normal investor) follow the crowd into irrational exuberance and doing stupid things.
For example, back in 1999, a lot of old economy stocks were thrown out of the index, and substituted for red hot technology stocks such as Yahoo (YHOO) I would let you figure out for yourself how that worked out.
The other sin of the S&P index committee is that it didn’t include Warren Buffett’s Berkshire Hathaway (BRK.A, BRK.B) in the index until 2010. With my strategy, I can select the securities that fit my criteria, and live or die by their performance, as I am the one in charge of capital allocation in the family.
The fourth flaw with index investing that they are not a magic panacea for sure stock market profits. An investor who doesn’t know anything about investing, and is passively saving in index funds, can still lose money. They can lose money if they panic at the wrong times such as in 2008 – 2009 and sell everything. They can also lose money if they put money to work without taking valuation into account. The ordinary investor can find a way lose money even with idiot-proof index funds.
In fact, according to Morningstar, most investors in the Vanguard 500 index fund have underperformed the index by 2% per year over the past 15 years. The investor also needs to focus on valuation at the time of investment. You should not just blindly put your money in the market to work, without taking valuation into account. For anyone who bought S&P 500 index funds in the late 1990s, they were simply chasing market returns. This was not a smart decision, and the subsequent decade of low returns proved that ignoring entry valuation at the time of investment is not a good strategy.
The other thing is that while index funds have rock bottom expenses, they could still add up over time. For example, if you have a portfolio worth $100,000, you will end up paying $100/year in management fees. If your portfolio is worth $500,000, you will be paying $500/year for life.