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Alright, I’ll veer a little from my usual credit card rant. But that is something I have to get off my chest.

The Wall Street earlier that week finally published an a fact that I’ve known since the end of January that year - which is the S&P index has essentially been flat that decade. YES, you’ve heard it right, it has been flat that decade.

Which brings us to an interesting question? Are index funds as great as they are made out to be? Index funds obviously have their advantages. They are low cost and tax efficient. However, the main disadvantage is that they follow the market and an investor in an index fund essentially assumes market risk.

There have been many raving fans of index funds in the pf blog world. For example, Free Money Finance wrote a few posts on why he likes index funds. Advanced Personal Finance additionally recently posted his IRA asset allocation on the blog. Moolanomy has plus written about the virtues of having index funds as a sensible strategy. The Simple Dollar (an influential voice in the personal finance space) is plus a huge fan of index funds

Supporters of index funds will insist that most (or rather the average mutual funds fails to beat the S&P index by the faraway run). While that may be an critical statistics, they disregard the fact that most funds should never be compared to the S&P index. A large cap value fund for example, should be compared to the large cap value index (perhaps a Russell 1000 value index). But the biggest problem with index investing is that is the market is negative or flat, you perform as in line with the market. For a young person or couple, one might argue that one can ride it out in the “expanded term”.

However, you may not have a “enlarged term” horizon! How is that so? Well, imagine that you were 55 years old in 2000 and you plan to retire when you are about 62 or 63 years old (2008?). Back in 2000, you did some financial planning and you decided on an asset allocation model and implicit in that model is the fact that you would expect stocks to achieve an ‘average return’ of about say 8%. Your financial planner decides to get you invested in a Vanguard S&P index fund considering of its low cost. Well, the results weren’t too pretty.

Or imagine that you retired in 2000! I’m certain many folks did. Once again, let’s assume that you sat down with a financial planner and figured out an asset allocation model which should enable you to achieve your desired standard of living. But I bet that for most folks who retired in 2000, they would have to adjust their lifestyles. The S&P declined about 40% from peak to trough in the early 2000s. Now try telling these retirees that index funds are great!

The fact of the matter is that : Absolute Returns DO Matter - not relative returns. It’s no use saying that your portfolio declined 30% in the early 2000s

and be happy considering it outperformed the S&P!.

The other problem with indexing in general is that most indexes are weighted by market capitalization. that presents a problem considering as the market rallies, you end up buying more expensive stocks! So as you were dollar cost averaging into a typical S&P index fund in early 2007, you were buying by 35% of financials (which was the weightings thereupon - it is now lower). Or consider that in the late 80s whether you bought an EAFE index (for worldly investing), 80% of the soon after EAFE composition was in Japanese stocks. And they now comprise only a fraction of that. Hence, you would have ended by buying Japan at inflated prices! But hey indexes are the way to go and they are low cost!

But can you on hindsight pick funds that will put you ahead? Well, there are funds that would have given you positive returns that decade (talking about large cap funds - since the S&P is a large cap index). And anyone could have picked these funds in 2000s. The thing they had in common even in 2000 was a 10 year track record. Here are some gems :

For those of you value believers

Eaton vance Dividend Builder A

Dodge and Cox Stock - a favourite.

American Century Equity Income

General Large Cap Stocks

American Funds Fundamental Investments - Hey - it’s American Funds.

Davis New York Venture - which is actually a value fund that has been categorized as large blend by Morningstar.

The reason I wrote that post is that I think too much credit has been given to index funds and not too many posts have been written on risk versus returns. With an index fund, you are essentially accepting market risk. But the biggest danger to expanded term wealth is actually the volatility of your portfolio. Obviously, you could lower the volatility of your portfolio with proper asset allocation. But most posts written on the web and even in mainstream publications always energize a large portion of your investments to be in stocks considering “in the faraway run”, they outperform most other asset class. Well, from the peak of the stock market in 1929, it was not until 1054 that the market was essentially at the same levels (yes more than 2 decades). From the peak of the early 70s, it wasn’t until 1985 that the indexes caught up with those levels. And now, it’s been flat for 9 years since the beginning of the new century. Like I said, whether you are in your early twenties, day is on your side. But the those in their 50s or nearing retirement age, you have to think enlarged and hard about their investment strategy.

And I propose that one takes a distant hard look at the assumption that index funds are the end all and be all. They obviously have a place in your portfolio and I’m not saying it’s poor. But too little has been written about their downsides.

Orginal post by Mr Credit Card