The big New York newspaper is at it again. Instead of the usual full frontal praise, Mark Hulbert gave yet another subtle pat on the back to index funds this month.

Brokers everywhere will tell you that small investors should buy index funds—meaning those of us with less than a billion to buy their valuable time and attention. Message from New York City to us: “Rest your pretty little heads—stop reading financial reports and analyzing stocks. Buy index funds. Average is good enough for the likes of you.”

And when the average is negative for eight years, do they change their tune? Heck no… they still tell people index funds are what smart people buy. My foot.

I’ve met hundreds of people who invest in index funds, but I have yet to meet a person who did it without being talked into it by some combination of insults and funny math. Add in phony comparisons to “funds in general” rather than to individuals making particular stock choices, lack of better alternative choices in the company 401 (k), or deep insecurity.

For every other kind of fund, investors at least make a decision to buy based on some rational footing—“this fund has earned 16% a year, that one earned 10%. I’ll take the one that does better.” Or, “this fund is 40% in bonds, so it’s got more safety built in, and I prefer its steady performance to the risk of the other one.”

The reasons may involve errors. Notoriously, funds that have done best one year have an embarrassing tendency to consort with the laggards the next. But I’ve found that investors’ decisions are still respectable efforts at taking responsibility, which I admire. And when it comes to investors buying stocks one-by-one instead of shopping for fund managers, a whole lot of thought goes into the process, as I have discovered from talking to investors.

When it comes to index funds, though, it’s usually a case of being embarrassed into it by some sharpie who implies we’re all too stupid to do any better. Or that we’re too small to compete against institutions that know everything first. Nobody can beat the market, so just buy the market, the aloof pro says to the poor little sucker. And boy have investors gone for it.

I should add that I have also met hundreds of people who made money in stocks, and not a one of them has ever told me it was thanks to buying index funds. Some made money in areas I don’t know and wouldn’t succeed in myself, like Canadian junior golds. Others did it in growth, value, tech, dividends, buying naked puts to accumulate blue chips…

But Wall Street and the newspaper from the same city want us in indexes. They are evidently winning the war against the public’s lack of self-confidence.

This chart was just released by Standard and Poor’s last week. It shows $1.4 trillion dollars in S&P 500 index funds. S&P puts total index fund investments at $1.7 trillion, which includes mid-cap and small-cap and other index funds as well as the S&P 500. Wait a minute; let me put all those digits in front of you… $1,700,000,000,000.00. The words make it seem so tiny. It’s not.

This does not even include the stealth indexing that goes on. A number of mutual funds pretend to be actively managed but actually shadow the S&P 500 by heavily investing in the larger S&P 500 companies.

This chart makes an interesting contrarian indicator. Index investing peaked in 1999, the last full year of the 1990s bull market. But if it appears that investors wisely got out of funds in 2000, looks are deceiving. If everyone froze and left their money in place, adding none, the 2000 bar would have been a fourth lower than the 1999 bar. This small drop means that investors were still adding money to index funds as the market fell. Probably because the market fell—everything else was suddenly confusing.

Then, indexing was least popular in 2002, when astute investors were setting up for a breakout bull market that began early in 2003. Anyone who bought index funds in 2002 did much better the following 12 months than anyone who bought them during the peak years.

Now, indexing is extremely popular again. I certainly hope the current high interest in indexing doesn’t foreshadow a 2000-style breakdown. It’s more likely, though, that the current popularity has to do with the market’s lack of direction.

Should you be in index funds?

Well, if your plan is to match the market over a very long term and you don’t want to work, sure. But don’t overestimate what the market returns. The U.S. average from 1802 to 2002 was 9.2%. Early data are a little shaky in places regarding dividends, but another study of returns from 1900 to 2000 (Triumph of the Optimists, Elroy Dimson, Paul Marsh and Mike Stanton, Princeton University Press, 2002) makes the case more clearly. Total returns were 10.1% average per year, and returns minus dividends were only 5.4% a year.

At that pace, considering the modern low dividends, investors should not expect anything close to the 12% a year they’ve heard investing pays—at least not from floating on the lazy river of index funds. I wouldn’t count on anything higher than 6% total for the long-term index return for the next many years. Even that’s optimistic.

And want to hear the ultimate comeuppance to index investing? It’s hard to be above average, but not so impossible as you’ve been told. The Vanguard S&P 500 index fund was launched in 1976. At the time, there were 308 mutual funds included in Forbes annual fund survey. Several have gone out of business or been merged into other funds. Even so, 29% of those funds beat the S&P 500 over these past 32 years. That’s far too much to be an accident.

The takeaway lesson here:

• The media are still pushing a bad idea. Without dividends, investors will be lucky to average 6% a year over a decade of investing in index funds. And that’s before any inflation.

• What’s more, the market enters a prolonged bear market about every third decade. It typically takes 10-15 years of investing to overcome the losses from a prolonged bear market if you enter at the peak of the previous bull market and do not own or buy any market-beating stocks during the bear market.

• Plenty of funds have beaten the market in the long run. Academic studies are set up to exclude them.

Respectfully,

Lynn Carpenter

Source: They’ve Got a Lot of Nerve