Index Funds: Are We All Bozos On This Bus?

Ever notice a disturbing trend that you see going on unimpeded, while no one thinks anything is out of the ordinary, or could lead to a result no one else but you fears? And you wonder why it hasn't caught the attention of anyone but you, but the trend never seems to stop? "Why doesn't anyone say anything? Don't they see what's happening? Anyone out there?" And then, at long last, someone does, and all of a sudden, what was once a private concern goes mainstream. And then you tell yourself, "Well....at least I told myself."

One of the strongest investing trends in the past few years is the use of index funds. And the reason for this trend is that they have a few advantages over the traditional mutual fund, which is an investment vehicle that has perhaps siphoned off trillions in fees and expenses from American investors over the years, most cruelly, in 401(k)s. Most mutual funds can't beat market averages, and there is a good reason for that as well: the loads charged, the back end fees the hefty remuneration of the fund managers, plus the regulatory demands and cost of endless disclosures, have rightfully made the thing a dinosaur.

Back in the 80s, when the markets were taking off as the Fed lowered rates- the money from those 13% yielding CDs had to go somewhere- there were funds like Fidelity's Magellan, and back in those times, all you had to do was send them your money, and Peter Lynch did the rest. The fund performed wonderfully, but in a way, its success would be its own undoing: in 1977, when Lynch took over the fund, it had a mere $18 million in assets. In those days, even the so-called "mass affluent" were more likely to buy bonds, big cap "safe" stocks, and Ginnie Maes, as that generation's memories of the Depression still scarred. When those massive inflows began to flow out of CDs, they started going into mutual funds. Now, everyone was a player. Lynch performed brilliantly, outperforming every mutual fund out there, but it must be said that in those days, he had little competition, and when the market is getting billions in inflows, well, all it can do is go up. When Lynch left in 1990, Magellan had $14 billion to manage. Just two years later, it had $20 billion. By 1996, it had over $50 billion in assets under management, and that is a hard thing to tackle. Performance was beginning to stumble, and the fund was closed for the next decade to new investment. But the ensuing years would not be kind to the fund.

When you run that kind of wad in assets under management, the assets are managing YOU. You're not investing in the market. You ARE the market.

There was pretty easy money to be made back then. For years, even just stuffing a part of your paycheck in something like General Electric or IBM provided you with a solid nest egg, if you had the discipline to save. Dividends were raised like clockwork, and reinvesting them was even shrewder. But mutual funds offered the promise of professional management, diversification, and no decisions to be made for the average investor. And after gorging on those fat yields, money they had, and money they gave them. Thanks to the wild success of Lynch, dozens of imitators came along. Soon, there were more fund names than stocks. In order to differentiate holdings, "sector funds" came into being, but these were usually just easy ways to skim money from investors. Want a "Real Estate Fund?" Most of them simply had 10 obvious choices, like Simon Properties, S.L. Green, Mack-Cali, all of the usual suspects. For this, a load of over 5% could be charged upon application, fees could be skimmed, and the fund manager could earn over $300,000 a year with barely any portfolio turnover. But what did the public know?

It took years, but eventually a better alternative came along: index funds. Since the fee structure and a trickier investment environment (See: well known stock with negative cash flow for 10 years rises 8300%) made "beating" the market harder, people reasoned all they had to do was buy a basket of stocks, most commonly, simply the ones that made up the S&P 500, and you didn't have to beat the market. You WERE the market, so why risk the chance of attempting to beat it with professional management? Sounds logical, right? I mean, what could go wrong?

Well, that's where that "disturbing trend" I mentioned comes in. And it's noticed by no less than the man who started the revolution, Jack Bogle of Vanguard Funds, who is credited with inventing the Index Fund. And an article titled "Bogle Says If Everybody Indexed, Markets Would Fail Under Chaos" comes along on my feed. At long last, someone read my mind, because that is precisely what has been concerning me. Week after week, fund inflows are tallied, and the numbers piling into index funds are beyond staggering, and show no signs of slowing. And that's what was bothering me: if a huge portion of the investing public is long the same trade, where is my "market?" An ever growing slice of investable assets are being placed in a single one-way bet. And indexes don't allow for risk balancing. They simply are. When does it get to be a problem when there are fewer and fewer investors taking the other side of the trade?

Mr. Bogle continues:

“There would be no trading, there would be no way to convert a stream of income into a pile of capital or a pile of capital into a stream of income. The markets would fail.”

Yes, they would fail, and thank you for confirming my fears, as billions pour into these almost identical, unguided instruments without respite.

"Passive equity investments may become as much as 45 percent of the mutual fund industry within five years as investors move to low-cost funds, Bogle said in an interview on Bloomberg Radio in March." It’s now between 20 percent and 40 percent, Bogle said on Saturday, and could reach 75 percent without posing a significant market risk."

Except Bogle is missing a point here. People just aren't switching from active "mutual fund" management, which he probably sees as his life long nemesis. People are abandoning constructed portfolios altogether. And that could be a problem.

When a prospect or client comes to me with some assets, I can allocate for a balance of growth or income. I can protect some assets with straight fixed income pieces, or preferred stocks, and balance out all kinds of risk variables. I can take taxes into consideration. All of these factors affect investment outcomes. With an index fund, the investor is flying "dead stick." There's no way to adjust, re-allocate, de-risk, or perform any kind of investing that truly conforms to the investor's real needs.

In any case, we're probably a long way from seeing this as an issue. At least I hope so. We haven't seen how the market and these funds would react if a "Lehman event" took place. But it could turn out to be more interesting than we believed.

It usually is.

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FloMartin Securities, Inc.

Donald R. Davret, Investment Advisor Representative

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