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By rclosch
August 29, 2003

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FatOtt Says:

I searched for any fund names since 1990 whose name contained the word "Index" and found the following information:

- There were a total of 585 funds whose name contained the word "Index".
- 46 of those funds contained either the word "Bond" or "Treasury". The remaining 539 funds appear to have names that indicate they are equity funds, so I'll assume they are.
This was an interesting post, and it certainly is nice to read posts that contain thoughtful research. Beats the hell out of all those threads where everyone just stands around throwing pizza at each other.

My objection is not to index funds per se, but to the notion that there is one particular index fund that represents the over all market, and that purchase of such and index is a one-decision investment that can be bought and held forever. This may have been a workable assumption ten years ago, when there were only one or two index funds that mattered, but today, as FatOtt has pointed out, there are 585 index funds.

Because of the Globalization of the world economy and the rapid expansion of its capital markets, Indexes have sprung up all over the world. These indexes and the funds that track them are sector funds tracking the performance of a national market or some sector within a national market. Today, Index investing is basically placing a sector bet.

I have nothing against sector investing, there may times and places where they can be helpful investment tools, such as when investing in countries other than the US were many securities are not available to US investors. But sector bets should be recognized for what they are. And they is not necessarily the best choice for inexperienced investors

I like Mad Capitalist's Idea of blending the S&P 500 and the Wilshire 4500, but this smells to me like a sector bet, not only are you changing weight between two different American sectors, but you are choosing to ignore the rest of the world.

This last part bothers me because in betting only on the US you may be ignoring the most important decision investors will face over the next ten to twenty years. Foreign Equities have not been good investments for the last ten years as capital has flowed into large cap American companies, but now there is a valuation gap between the US and the rest of the world. In addition to this valuation gap, there are a lot of areas, such as Asia, Latin America, and Eastern Europe where future GDP growth may come a lot easier than it will in the mature economies of US and Western Europe. I have no idea how all this will work out, but telling someone to put all their money in a S&P 500 index fund and forget about it, is not my idea of doing them a favor.

Intellectually I object to Index funds because they support massive misallocation of Capital. The function of the capital markets should be to allocate capital to companies that use it most efficiently, but the popularity of indexing in the 1990's caused money to flow into the stocks of Large cap American Companies with no regard to whether those companies were able to use the capital effectively.. There a nice irony here. The more popular that indexing become the more it was prone to creating inefficiencies in the capital markets. The indexing tide raises all boats in the index without regard to the intrinsic value of the boat.

The money flowed in; raising the value of the companies in the index (and the relative performance of the index funds) till the stocks became over valued relative to stocks that were not in the average. The inevitable result was our present period where the stocks in the index are under performing the stocks that are not in the index. It seems to me that all future Index investing will experience a similar pattern, as an index becomes popular the companies within that index will become overvalued and a correction will follow. Mr. Market is still bipolar. The prudent investor will sell to him when he feels his stock, ( or index) is overvalued, and buy from him only when what Mr. Market is selling is under valued. .

The easy money from rising stock prices eventually produces all kinds of bad behavior. It finances capital spending for expansion projects where the projected demand never materializes. It produces countless mergers where the only real motivation is CEO ego gratification.

Even today, many of the largest companies in the S&P remain over valued and with a considerable mess left to clean up. The corrective process may take years. Look at the Nifty Fifty of the Nineteen Seventies, some of those companies never recovered from the mistakes they made in the sixties and seventies and for the ones that did recover it was a long process. In Japan the correction has been going on for twelve years and stock market is still in the tank.

Finally, there is no way to learn about investing if you are not participating. The best education comes from the mistakes that you make. You are never going to learn about valuation if you do not buy stocks. For capital markets to work properly, and send capital to companies that can use it efficiently, we need educated investors.

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