Friday, August 02, 2002

The Index Solution under Attack

The two-year bear market has lead journalists and pundits to question some previously-thought sound methods of investing. Daniel Gross has recently taken on the index solution -- investing in a mutual fund that tracks a major stock market index such as the S&P 500 to achieve stock market exposure for long-term assets. There are some fundamental mistakes, however, in Gross’s analysis which could prove dangerous to ordinary investors.

First of all, Gross begins by arguing that the S&P 500 has been regarded as a “safe place” for long-term investors. Of course, no responsible financial advisor would ever call any kind of stock fund, index or actively managed, safe. Individual stocks or stock mutual funds should always be reserved for long-term money and used by investors who can tolerate significant fluctuation in the value of their long-term investments. None of the strongest and most articulate proponents of index investing, Jack Bogle and Burton Malkiel for example, whose names and arguments are curiously absent from Gross’s piece, has ever argued that a major equity index was a safe investment.

Gross complains also that the S&P screening criteria, such as requiring that a company is representative of the American economy, that it have high capitalization, and that it have four consecutive quarters of profits, allowed older economy names to be replaced in the index by more speculative technology and telecommunications companies when they were trading at or near their peaks in the late 1990s. Moreover, the need of index funds to include the new names further raised the prices. But does it really make sense not to have Qualcomm or AOL in a major index? However much the prices achieved by technology companies in the late nineties may have been artificial, the companies were representative of the economy as reflected by capitalizations. This may sound like a tautology, but It is not the S&P’s function to moderate investors or to speculate itself on what prices or capitalizations should be. Gross compares the much more static (and less representative) Dow Jones Industrial Average favorably to the S&P 500 because it has held up better in the recent decline, but his complaint amounts to the fact that the S&P was too successful in representing the market. Prices and capitalizations are what they are -- a contradictory combination of serious reflection on the fundamentals of a company and powerful human emotions; this is why the stock market is a perennial risk.

The proponents of index investing defend indexing as an alternative to active stock portfolio management for long-term assets, not as a viable option to investors who are saving cash over the next eighteen months for a home purchase. The main arguments for indexing over active stock management which I take from Burton Malkiel’s classic, A Random Walk Down Wall Street, are as follows: 1. Index funds have much lower management fees and trading costs than actively managed funds. 2. Because index funds trade little, they are also tax-efficient. 3. Although some investors have displayed them, consistent market-beating skills are extremely rare, and it’s impossible to spot them before the fact. Gross does nothing to overcome these arguments, despite his account of the recent fall of the S&P 500. To cite the Dow’s recent comparative out-performance (with its only 30 stocks) is not adequate, especially since it has been hurt plenty by the recent market decline anyway. Index investors are generally a savvy lot who understand the risks of the stock market. Most of them know that it's preferable to own a more representative index such as the S&P 500 or, even better, a "Total Market" index fund that reflects the Wilshire 5000. By contrast, there are many less sophisticated investors who, having sunk their entire portfolios into Janus and other aggressive growth funds, wound up in worse shape than any index investor.

Gross’s piece is dangerous because it may lull ordinary investors, average people trying to save to send their kids to college and fund their retirement, into the opinion that it’s easy to beat the major indexes. This is just what self-serving stockbrokers and portfolio managers want them to believe.


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