It's Time to Reinvent the Index Fund

Bigger isn't necessarily better. That old trope has long since been disproved -- and in fact, I'd go so far as to say that you'd be insane to believe that "bigger" and "better" always walk hand in hand.

Yet the assumption that they do continues to govern the low-cost index fund industry, one that you likely have a good portion of your life savings invested in. My contention is that the flawed "bigger is better" reasoning that underlies index investing has exposed American investors to needless amounts of risk over the past few years and ultimately cost Americans billions of dollars of their hard-earned money.

Thus, I believe it's time for a change, and I have a plan for getting it done.

First, some history
The first index fund for individual investors was invented by Vanguard founder Jack Bogle in 1975. Bogle's contention then -- as it is today -- is that most active fund managers cannot outperform the market average and that even fewer active fund managers can outperform the market average net of the fees they charge investors to manage their money. This was true when Bogle made the claim in 1975, and it has remained true in the more than three decades since.

So Bogle created the Vanguard 500 Index to track the performance of the widely followed S&P 500 index -- minus a minuscule expense ratio. And the Vanguard 500 has been a smashing success.

The fund grew to be the largest mutual fund in the world by 2000 and today boasts more than $61 billion in net assets, and charges just 16 basis points per year in expenses. Even better, since its 1976 inception, the Vanguard 500 has returned 9.3% annually to investors. That performance, available to anyone who had the wherewithal to invest, would have turned $1 into more than $18 today -- one of the best and longest track records in the investing world.

Yet it's been a pretty bad year for the Vanguard 500. In fact, it's been a pretty bad three years, five years, and decade for the Vanguard 500. As of the end of February, the fund was down more than 43% over the past 12 months and has lost more than 3.5% annually over the trailing-10-year period.

Those are not good numbers. They're the consequence of a flawed methodology.

It's not Jack's fault
The problem is that the Vanguard 500 tracks the S&P 500, an index that was designed in 1957 to track the performance of the 500 largest companies in the United States. Back then, S&P decided that the influence each company would have on the index would correlate directly with its market cap. So the largest company in the group would have the most influence, the second-largest the second-most, and so on down the line until the smallest company -- the 500th company -- would have the least.

That's why, at the beginning of this year, the Vanguard 500's 10 largest holdings looked like this:

Data as of 12/31/08.

Add it up and these 10 companies today account for more than 22% of the Vanguard 500's holdings just because they're the biggest companies out there, but not necessarily because they're the 10 best investments or the 10 highest-quality companies or the 10 best-run corporations. You own them -- if you own an index fund (and you likely do) -- because they're big.

That doesn't seem like a very good reason
If you don't have a problem with that flawed reasoning yet, just take a look at what the top 10 holdings of the S&P 500 Index -- and therefore the Vanguard 500 fund -- looked like in 2007:
 

Data as of 9/30/2007.

And in 2006:

Data as of 10/16/2006.

That's right, as of late 2006, your "diversified" index fund had half of its top 10 holdings in troubled financial stocks, four of which -- GE, Citigroup, Bank of America, and AIG -- now trade for less than $10 per share and two of which -- AIG and Citigroup -- have aggressively flirted (you teenagers know what I'm talking about) with total collapse.

This is a problem
These companies are a significant cause of the Vanguard 500's dismal recent performance. JPMorgan is down 42% since October 2006, Bank of America 85%, Citigroup 94%, and AIG 98%. If you owned an index fund, you owned these four stocks. More troubling is that you had no good reason to.

Remember, the only reason these companies were central components of the fund was their size. We know now that the reason they had gotten so big was because they were taking on extraordinary risk in the pursuit of short-term profits and bonuses and dangerously leveraging their balance sheets in order to squeeze out growth. While dangerous moves like that are hallmarks of big companies that have gone off the rails, they are not the hallmarks of good companies.

Yet the Vanguard 500 -- our country's most popular mutual fund -- is 100% quality-blind. And while The Motley Fool has long been a proponent of low-cost, long-term index fund investing as the best solution for most individual investors, we've also long said that the best way to earn good returns in the stock market is to buy and hold high-quality companies. Given the events of the past two years, it now seems impossible that these two methodologies have anything in common.

Where does that leave us?
The fact is that bigger is not better. Better is better. And index funds need to be reinvented for the better.

That's because over the past 36 months, individual investors who seem to have done everything right -- working hard, saving, and investing regularly in a low-cost index fund -- have found themselves dangerously overexposed to an ignoble and/or incompetent U.S. financial sector. 

Even if they were paying attention to the news and watched as Countrywide Financial, Fannie Mae, Wachovia, and Washington Mutual all imploded -- and they said to themselves, "Man, I'm glad I own an index fund and not any of those" -- it turns out that by late 2007, these troubled companies still made up a significant portion of the Vanguard 500. Financials on the whole made up nearly 20% of the S&P 500 index as of September 2007.

The news headlines around that time would have convinced even a daft individual investor that that was a dangerous amount. Key executives were departing these companies, mortgage divisions were closing, regulatory agencies were beginning to investigate, and a looming credit crunch was causing these companies to issue tepid outlooks. The Vanguard 500, however, did not catch on. Again, it's quality-blind.

Why would anyone own a fund like that?

A method to the madness
Of course, there is one spectacular reason to own the Vanguard 500: low fees. There is no cheaper investment option out there today, and history has proved beyond a shadow of a doubt that investors do better over time by limiting their frictional costs, such as taxes, trading costs, and annual expense ratios.

Further, there's nothing wrong with the government or media using the market-cap weighted S&P 500 index to track the health of our economy. The biggest companies will tend to be the biggest employers and have the biggest effect on commerce, so it's worth knowing when they're in trouble. My doubts are about its logic as an investment choice.

Here's what I propose instead: a low-cost, quality-weighted index fund of large U.S. companies. No such product exists today, but I believe it would prove to be immensely popular with individual investors. Moreover, by rewarding companies for having good corporate governance, creating value for outside shareholders, and treating their customers and employees well with inclusion in this index, we'd establish an incentive within the system for companies to do right by their constituencies rather than pursue growth at any cost (or GAAC!, which also happens to be the correct reaction if you encounter a company that's doing this).

After all, imagine if you were a CEO and you steered your company into the quality index. That would be a proud day. On the flip side, if you got your company kicked out, your employees, board of directors, and shareholders would have some questions for you.

Best of all, my preliminary research into this quality index indicates that it would have outperformed the Vanguard 500 significantly over the trailing one-, three-, and five-year periods.

Here's how it works
The challenge with a quality index is to devise the framework that would tell us if a company is worthy of inclusion. After all, it's not clear what factors make for a high-quality company, what factors are just symptoms of high-quality or low-quality companies, and what factors can be measured in an objective way.

Recognizing those facts, here's the hypothesis that crack research analyst Nate Weisshaar and I started with: "A high-quality company is one that treats all of its constituents -- shareholders, employees, and customers -- well." The question then became: What existing data sets can we use and smash together to come up with a list of high-quality companies?

There are lots of answers to this question, and you may well have your own answer or criteria you'd like to add to ours (and if you do, please add them in the comments section below). This, however, is what we came up with.

A blueprint for better
When it comes to companies that value their shareholders and shareholders' capital, here are the measurable criteria we like to see:

• Insider ownership between 5% and 50% of outstanding shares (showing a management team that's committed to the company but doesn't necessarily control the company).
• Limited to no takeover defense provisions such as poison pills that protect entrenched management.
• Limited shareholder dilution over time (indicating a respect for the company's owners).
• Either good returns on invested capital or a common stock dividend (evidence that the company thoughtfully allocates capital).

When it comes to measuring how a company treats its employees, we looked for inclusion on Fortune's list of the best companies to work for anytime in the past five years, as well as long-tenured management and a senior executive team that has largely been promoted from within.

And when it came to measuring customer satisfaction, we looked for the company's inclusion as one of the world's top brands, a spot on the list of BusinessWeek's "Customer Service Champs," or a high net promoter score. In order not to bias our index toward consumer-facing companies, however, while we overweighted our index toward companies that delight their customers in addition to their shareholders and employees, we did not eliminate any companies from the index unless there was evidence that customers have a clearly negative opinion of them. In other words, if customers have no opinion, the company still made our quality cut.

What we ended up with
This methodology is not perfect and is a work-in-progress, but the early results are promising. We ended up including 85 companies in our Fool Quality Index (the FQI for short) and weighting toward the companies that have clear evidence of working in shareholders', employees', and customers' best interests. Here are the top 10:

Is this a perfect list? Probably not. Is every one of our 85 companies a truly high-quality company? It's hard to know. But what we do know is that this index outperformed the S&P 500. Over the past year as of mid-March, while the Vanguard 500 was down 39.4%, the FQI was down 30.5%. Over the past three years, the Vanguard 500 was down 38.9%, and the FQI was down 27.9%. And over the past five years the Vanguard 500 fell 26%, while the FQI was actually up 9%.

But this makes sense. A diverse collection of well-run, high-quality companies should outperform a random collection of big companies over time.

What now
In almost every other industry, the demands of the customer are clear. We want better products at lower prices. In the financial industry, however, it's been the reverse. Over the past decade, for example, we've seen the rapid rise of the hedge fund -- unregulated entities that took leveraged risks and generally bilked investors for a 2% annual management fee and 20% of profits. These were largely inferior money-management products at higher prices, and yet wealthy investors snapped them up like hotcakes.

That's left the market-cap-weighted index fund as the best low-cost option available to investors, but the index fund is not as good as it should be. That's startlingly clear now given the enormous positions the Vanguard 500 index held in troubled financials in 2006, 2007, and 2008, and the losses that that quality-blind approach has caused for hardworking American investors.

It's time for the financial industry to reinvent the index fund -- to provide a low-cost, diversified fund that holds a portfolio of high-quality companies. This should be the future, but it will only happen if customers like you demand it. Do just that in the comments below.