Your Index Fund Is Making a Bad Investment

Index funds have given many small investors a great solution for getting exposure to the stock market. Yet they're far from perfect. Sometimes, index funds do some pretty nutty things. But it's not really their fault -- because they're only following in the footsteps of whatever indexes they track.

Why an index fund?
Whether you invest in funds or individual stocks, you probably compare your performance to that of a common stock benchmark. Many investors use the S&P 500 index, which includes 500 of the largest U.S. stocks, as a guide to figure out if they're beating or trailing the broad market's return. The S&P 500 is so popular as a benchmark that it was the tracking index for the first index fund available to individual investors more than 35 years ago.

Index funds responded to the concept that active management increases costs while failing to improve returns in any predictable way. Although some exceptional managers beat the market indexes regularly, there's still a lot of debate about whether those results are because of skill or just luck. Those who believe the latter wanted a cheap, efficient way to match the market's average return, and index funds gave them exactly what they wanted.

Is Standard & Poor's smart?
But it's important to understand that when you buy an index like the S&P 500, you aren't investing in a completely passive way. Standard & Poor's, which manages the S&P 500, makes changes to its benchmark index from time to time -- and some of those changes have turned out to reflect some really bad timing.

For instance, consider these ill-timed moves:

  • In 2000, the S&P 500 replaced many old-economy stocks with up-and-coming tech names Broadcom (Nasdaq: BRCM  ) and JDS Uniphase (Nasdaq: JDSU  ) , among many others. It also added utility Dynegy (NYSE: DYN  ) in the wake of the deregulatory fervor that eventually led to Enron's demise.
  • More recently, after kicking Ingersoll Rand (NYSE: IR  ) out of the S&P 500 in early 2009 in favor of Quanta Services (NYSE: PWR  ) , S&P returned it to the index in November. During the time it was out of the index, Ingersoll Rand's stock almost doubled, while Quanta lost nearly a quarter of its value.

When you think about it, it makes sense that the S&P 500 would typically involve buying high and selling low. After all, a company won't be eligible for inclusion in the index until it grows to a certain size, so you'll automatically have missed the best high-growth period that the stock went through to reach large-cap status. Similarly, once it's in the index, a stock may well have to fall a long way before it gets so low that Standard & Poor's tosses it out of the index.

How now, Dow?
Nor is Standard & Poor's unique in its decision-making prowess. The Dow Jones Industrial Average has had well-documented bad timing in some of its choices. Adding big tech names at the peak of the bubble was an obvious mistake, but even in the run-up to the financial crisis, the Dow made questionable calls.

Adding Bank of America (NYSE: BAC  ) in early 2008 proved disastrous for the index, as the bank stock was hit hard during the market meltdown. But then the Dow waited until after the market's lows to evict Citigroup (NYSE: C  ) from the average, exposing investors to nearly the full downturn in the bank's shares.

What to do
Despite their flaws, index funds still have clear benefits. Given how few active fund managers manage to outpace benchmarks like the S&P 500 over the long haul, even the shortcomings of the companies that manage those benchmarks seem less detrimental than bad investing decisions of many fund professionals.

Never think, however, that an index is the be all and end all of investing. As a tool, it can serve you well, but you shouldn't be scared to venture beyond it seeking your own outperformance. After all, even index funds do dumb things sometimes -- and will continue to do so well into the future.

Some of the best index investments are ETFs. Find some smart ETF picks in The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery."

Fool contributor Dan Caplinger puts up with the foibles of index funds. He doesn't own shares of the companies mentioned in this article. The Fool owns shares of Bank of America, and through a separate account in its Rising Stars portfolios also holds a short position in it. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is our best investment ever.


Read/Post Comments (6) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 15, 2011, at 6:18 PM, Merton123 wrote:

    The art of investing is selecting a non representative sample (portfolio) that will provide a different total return then the population (index). Very few managers have been able to accomplish this statistical feat for the long run per the article above. The real question is which index fund will provide the best overall average return for the next 10 years? I believe that Vanguard Total World Fund (VTWSX) since it has emerging market, japan, europe and the United State exposure. I believe that VTWSX will outperform the Vanguard Standard & Poor 500 Index fund since the majority of growth is occuring outside of our borders.

  • Report this Comment On January 18, 2011, at 9:20 AM, miteycasey wrote:

    So out of 500 stocks it's selling 2-3 a year at their low and buying 2-3 at their high, still gain 5-10% on average, and you are complaining?

    Yes, it's a flaw in the system, but how many people buy the incoming stock a few weeks, or months, before it's added to an index to realize the gain of all the fund managers who must buy the new stock so they say they are tracking the market?

  • Report this Comment On January 18, 2011, at 2:15 PM, BenSaanich wrote:

    I don't see the point of this article. Indexes are not investment portfolios, they are designed to represent [some sector of] the market. That is, the primary goal of an index is not to make investment decisions. The fact that investing in an index fund would follow the decisions made by the controllers of the index is beside the point.

    In a sense although indexes are not static and therefore index funds' holdings vary with time, your investment in index funds is not primarily in an asset designed to maximize your returns.

  • Report this Comment On January 18, 2011, at 3:02 PM, Merton123 wrote:

    Ben Saanich - The efficient Market Hypothesis basically states that over the long run you can't get more then the market (i.e., index) rate of return. There are some people who for short periods of time (i.e., maybe a couple of years) get excess returns but then you have convergence to the mean occuring and those same people underperform the market (i.e., index fund) for around the same amount of time. Actual experience appears to support the efficient market hypothesis. There are a few people who for long periods of time (i.e., couple of decades) have consistently outperformed the index (i.e., market) but that could be a statistical fluke? I am now going to hide underneath the table and watch see the flurry of responces come forth :)

  • Report this Comment On January 18, 2011, at 3:34 PM, Merton123 wrote:

    We actually have a great opportunity to test the efficient market hypothesis today. Motley Fool has come out with two mutual funds. Motley Fools brand has become synonymous with outperforming the index. If there is anyone with the experience, desire, knowledge, and so-forth who should be able to year in and year out bring in excess returns (i.e., returns greater then an index) it should be Motley Fool. Motely Fool independence fund has gotten off to a good start. We will see if they are able to avoid "convergence to the mean" within the next five years time frame.

  • Report this Comment On January 19, 2011, at 10:58 AM, ikkyu2 wrote:

    This is actually why I don't like index funds. When you think about it, if you buy a portfolio of 500 stocks and hold over a specified time period, one of those stocks is going to be the best performer over that time period, and one is going to be the worst.

    I really don't like the idea of holding all that junk - companies I'd read the balance sheet and jettison from my portfolio like a polyester leisure suit if I were managing it myself.

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