Like many other financial independence campaigners, I invest in index funds. They’re pretty awesome, I’m an advocate that if you’re investing with zero knowledge or don’t want to do detailed company analysis, you could do a lot worse than dripping money into an index fund.
However, it’s an absolute lie to say that this is risk free, as I have seen people claim.
Here’s a summary of the case against index fund investing and why investing in index funds isn’t risk free.
This post looks at the negatives of index fund investing so that you can make up your own mind.
Disclaimer: although I did pass the basic financial advisor exam, I’m not a regulated financial advisor. I don’t give advice specific to your circumstances and I don’t know if anything I write is appropriate for you. This isn’t financial advice, it’s education and entertainment.
Don’t trust your financial future to some random on the internet – do your own research.
Recap: what is an index fund?
For a more general look at funds: I wrote an early post looking mainly at Exchange Traded Funds (ETFs).
An index fund is an investment vehicle that you buy units in. The fund manager invests all the money from these units into shares for you. Rather than make their own decisions about what to buy, they simply buy from a pre-determined list, called an index. This takes the human out of the equation and usually makes the fund cheaper to manage, as the manager doesn’t invest much time or effort in share analysis.
The index part
The index isn’t usually designed by the fund provider, although some are. The more common indices (that’s the correct plural of index) are designed by Morgan Stanley Capital International (MSCI), Standard & Poors (S&P), FTSE Russell (FTSE) or Dow Jones.
Honestly? It doesn’t matter too much who produces an index. It’s just a big list of shares that meet certain predetermined criteria and their weighting by market capitalisation (in public companies, basically the market value of the company). Some indices have a cut-off for how much of an index (the “weighting“) a particular company can have.
You could, in theory, produce your own index. That would mean that you could write out a list of criteria and simply rebalance your portfolio every month or so to match the proportions in that. It takes a lot of time, but it’s completely possible. The key thing is that you need to take the human discretionary element out of it, which is what the whole point of index investing is.
Indices are usually long lists. The smallest I’ve invested in was 30 companies, and that fund has since adjusted its index to now take on a few hundred. This usually means your investments are diversified across companies, but generally still 100% in public shares.
Is an ETF an index fund?
Exchange Traded Funds can be index funds, but index funds don’t have to be ETFs. The key distinction is that ETFs are fund units you can buy on a stock exchange, but that’s a choice the fund manager has made. Many funds aren’t on stock exchanges and you buy and sell units in them through the fund manager.
This affects pricing. ETF prices are determined by market forces, so do wobble a bit from what the fund owns. Unlisted funds should simply be priced at what the fund value is with a bit of fees for purchase/management.
Quick summary of the advantages of index funds
Index funds have the following awesome advantages:
- They are cheap to manage, so you keep more of any growth. Yummy!
- Human bias is reduced, so you’re not at the mercy of the fund manager being consistently good.
- You don’t need any real knowledge to buy them.
- You only lose all your money if the entire index – often, the public side of the entire global economy – fails. Basically, apocalypse or Jeff Bezos winning monopoly and everything being replaced by Amazon.
- Small amount of money buys you into a big spread of companies.
Now comes the rub: the advantages of index funds conversely create disadvantages. These form the case against index fund investing.
Primer: the big disadvantages of index fund investing
Before I write another feature-length essay that takes your entire commute to read, here’s a quick snapshot of what I can see as the big disadvantages of index fund investing:
- They are cheap because all the reliance on analysis is delegated to one company writing the index, who may be wrong. They also don’t react to changes in market behaviour.
- Index investing is basically using an algorithm, just not necessarily a computer one. Algorithms can be played.
- You won’t learn from them and won’t know if they’re being manipulated.
- Awesome gains by one company are dragged down by losses from weaker companies. You can’t beat the average.
- With bigger amounts of money, you could simply diversify your investments yourself, picking only companies with real value (if you have the time).
I’m very aware that a lot of my readers are index-fund afficionados, and their natural amigdala response will be to throw their laptop/phone at a wall while summoning demons to eat my soul (?). Here’s a lovely comic by the Oatmeal to show you why this happens.
I will reiterate that I have done and continue to use index funds in my financial independence campaign. This is simply an awareness piece. It is always right to consider the other side, even if you disagree and come to a different conclusion at the end.
Now that I’ve alienated most of my audience, let’s press on!
Reliance on an index and cheap investing
Most of the disadvantages to index fund investing stem from this one point: you are reliant upon an index.
Index funds are cheap, so lots of people buy into them. It’s a smart play. As long as human progress continues to be made and publicly-traded markets continue to grow, it’s probable that investors in index funds will get a balanced slice of the pie. Managers don’t do any real thinking, they just set up a few buy and sell orders then carry on with their day.
However, this growth becomes self-fulfilling. Populations of most stable countries tend to expand. Predictably, on population growth alone, this means that more investors will put money into these indices over time. This makes the weaknesses of index funds exploitable by unscrupulous owners of companies that turn public.
Ponzi dynamics?
Everyone screams “Ponzi” for effect. I’m no different. Hear me out before you switch off, though.
Indices tend to buy up big chunks of stock markets, regardless of the merits of any one company they’re buying shares in.
The consequence is that this drives prices of shares up across the board. If the UK pours money into the FTSE 100, those companies will all be worth more, despite having done nothing productively different. In this situation, they aren’t better companies, they’re just more in demand.
Which becomes a problem then if people get spooked and cash out all at once. This is especially true in a time where dividends aren’t really an investor’s main focus and many companies don’t pay them. Demand suddenly drops and the index fund investors are left holding a bag that’s full of unproductive companies.
Effectively, index fund investing risks turning the equities market into a Ponzi scheme, whereupon the index funds are always the greater fools willing to buy.
The cash out of an unproductive company comes in the form of selling to a public marketplace in the knowledge that if they meet the criteria of an index the shares will be bought by someone else.
The difference between this problem and Ponzi’s famous pyramid schemes is simply that you don’t lose all your money if this gets called out. Ponzi would have taken every penny, but there’s always someone willing to buy a share – even if that’s at a big discount.
Fortunately, you expect that the index captures productive companies in its bag, too. The good ones usually cancel out the bad ones overall, but never say never.
Zombie Companies
A “zombie” company is one that’s basically unviable. It’s propped up by debt and/or breaking even, but has very little growth prospects and isn’t adding much to your portfolio, society, or anything.
They should be dead, buuuuuut…
Zombie companies often live on cheap debt. A lot of the time this is because interest rates are low and lenders are keen to make some money. This means that a lot of loans are given at high risk or with less diligence.
Companies borrow money against their equity. That usually means their share price, in public companies. They can borrow against property, like a mortgage, but a zombie company won’t have much of that.
If a zombie company makes its way onto an index, it can sustain its undead lifestyle for quite a long time. This leads to companies that should have quit a long time ago just dragging on and producing crap products for no real reason or gain.
Here’s a 2021 article by Hargreaves Lansdown that estimated 70 of the FTSE 350 companies (i.e. about 20%) were zombie companies at the height of the pandemic. Yes, around 20% of the biggest UK public companies weren’t commercially viable, but were sure to be included in index funds covering FTSE 350, FTSE All-Share or possibly all world indices.
Manipulating an index – making an index fund buy your shares
An index fund is basically an algorithm. By this, I mean it’s just a fund that follows rules and a pattern. There’s no judgement involved, or at least very little. Once the rules are set, that’s it.
The problem here is that rules can be bent. Unscrupulous companies will know about these rules in advance, as they are publicly available, and position themselves just so that they fit into the indices they want.
Here’s a link to the S&P500 ESG index. This index is 307 of the top 500 US companies that remain after an Environmental, Social and Governance filter is added over them. The top 10 companies forming the biggest holdings are shown below (as at 2 July 2022):
The more astute readers will spot that Exxon Mobil, the big oil company that produces petrochemicals, is a serious chunk of the fund. So much for environmental considerations! You’ll also see note that Amazon, a company that is famously brutal to its warehouse workers, is in third place. Social responsibility be damned!
These have snuck in because companies can lose points on one thing and gain enough on a different metric, getting themselves included in index funds where they really shouldn’t be.
Are index funds really that diversified anyway?
Vanguard’s FTSE All-World index fund has over 3,000 companies in it, but a quick check on JustETF.com shows that the top 10 companies form over 16% of the index.
The Vanguard S&P500 index fund, with 501 company shares in it (hmm… yes… 500…) is 28% weighted in the top 10 biggest companies.
Over 49% of HSBC’s FTSE100 index fund is invested into just the top 10 companies.
By now, I hope you get the point. The most popular index funds weight their holdings by market cap, so the big dogs of an index are the main things you’re buying. Success or failure of these companies effectively determines your growth, and a 100% growth of a tiddly company in the tail end of the index will barely make a dent in a 20% price decline of one of the top 3 companies.
While your money may never “go to zero” with index funds, as an entire economy has to become worthless to do so, you’re relying on the growth of the top 10 to drag your portfolio along.
This is a little offset because if a small company grows in rankings, the index funds will hold more of it. Similarly, if a big company shrinks in value, the index funds will hold less of it by proportion.
An alternative: picking quality companies to invest in
One alternative that avoids your capital being used to prop up unviable companies and artificially inflate whole markets is to pick shares yourself.
Which is famously difficult.
The textbook answer I learned on my Diploma for Financial Advisors was that you need 30 investments to be suitably diversified. They don’t all have to be shares, but if you’re investing in equities there’s a damn good chance you’d have most of these as shares.
Interestingly, the Benjamin Graham approach in The Intelligent Investor is to be 25-75% weighted in (US) government bonds and then invest in up to 12 companies. The logic is that the bonds do most of the work, but you can really focus on the value of your holdings if there are only 12 or fewer to scrutinise at any one time.
There are different strategies to do this. Some people claim you should buy shares in products you use, since you know that the companies have decent offerings. Value investors look for decent p/e ratios and price to book value ratios, preferring to rely on actual results to justify fair buying prices. Momentum investors look for sustainable and increasing rates of price growth.
Basically, there are whole spreads of opinion on how to pick shares. They do all have two things in common though: they require a significant investment in time for research and you need to invest in your own education to follow them through.
It’s also usually quite expensive to buy into individual shares, although companies like Freetrade and Trading 212 have made this cheaper. Outside of these, the trading fees mean that it’s often not possible to diversify very well with small amounts of capital to invest.
Could someone else do this for you, as a service?
Another alternative: active funds investing
It’s also completely possible to outsource the selection of quality companies to a fund manager. You’d do this by buying units in either an active fund or a unit trust, which is effectively giving capital to a fund manager to invest for you.
These also have their own problems: you need to pay more for them in management fees, they are only as good as the fund manager, and they become worsened by hype.
No, really. The more well-known a fund becomes for its performance, the more money the fund attracts. This becomes a problem, because the buys and sells of big funds can be more than 3% of a company’s shares, so they become reportable on the public market news services.
That means in turn that the act of a high profile fund manager buying or selling shares is a trigger for price movement on the shares. Which is a problem. A simple “I have too many shares in BETAMEGACORP, I think I’ll sell a few and buy more in ALPHATINYCO” transaction can cause a huge price drop in the remaining BETAMEGACORP shares as the news services declare a change in the position.
Fees wise, an active fund can easily cost 1% or more per year in management fees alone. Compare that to around 0.09% for an S&P500 index fund.
It’s also possible for funds to perform badly, causing a catastrophic immediate outflow of capital and leaving the remaining fund unit holders with a whole host of problems. Technically an index fund could have this too, but the problems are fewer when an index fund just buys a bit of everything.
Why I use index funds despite the negatives
The point of this post was to highlight that index fund investing isn’t risk free. My whole philosophy is that all assets have risk involved, people just need to be aware to what those risks are and make sensible choices to protect themselves from the worst outcomes while exposing themselves to the best growth potential.
This is why I’m quite happy to look at gold and crypto as well as shares on this blog. It’s also why I do things like occasionally invest in startups on Crowdcube. My approach isn’t for everyone, but this isn’t an “everyone” blog.
Despite the negatives, I have been using index funds as the main part of my ISA and my entire SIPP. The main driver for this is that my workplace (I work in law) places restrictions on share trades so that I don’t end up accidentally insider trading. The other factor is that I don’t have infinite time to research companies thoroughly, so while I do pick REITs with a logistics sector focus and I have picked one or two shares, I have relied on index funds to give me some kind of reasonable diversification without too many costs.
I’m still quite early in my financial independence campaign. For me, the negatives are necessary because at my level the benefits outweigh them by quite a lot.
Where best to allocate my time…
At the moment, my time is better spent bringing money in than by scrutinising company accounts. I’m almost qualified (two more months…), I’m relocating and I’d be more effective in my campaign if I focused on keeping costs low or generating new income streams than trying to optimise my modest portfolio.
I do also use a robo-investor as well as index funds. Regular readers will remember my comments on these from the previous post about no-knowledge investing.
I’m pretty confident in my ability to identify value shares and choose for myself, but the whole process of identifying suitable companies, arranging balance of my investment pot and then getting permission for each trade through work just doesn’t make sense yet.
How might this change?
When I start clearing £100,000 in non-pension investments I might re-evaluate my position. At that level, I could make meaningful investments into chosen companies that are trading fees efficient, while giving myself enough diversification to manage risk appropriately.
I reckon I’m two years away from this, assuming that equities remain my main investment vehicle and not property or something else.
I could easily change this using Trading 212 and its awesome “pies” feature, which allows you to easily rebalance a picked selection of shares. It’s a cool feature, but after learning that someone from Andover (???) had previously accessed my Trading 212 account I’m considering moving all my funds from the platform. I’m also unhappy that they lend my shares out to enable short-selling, which is something that could screw me over.
For now, index funds are likely to remain a key part of my portfolio.
