2017-05-25 / Business News

To INDEX or NOT?

Index funds allow for no variables, but are good for those with no expertise

As those of you who have been reading this column for a while know, I am a big fan of Exchange Traded Funds and low-cost index mutual funds. By buying these securities, you are basically buy- ing a certain sector of the market. For example, you can buy an index of just technology stocks, high dividend stocks, international bonds or even the entire S&P 500. It is an easy and cost effective method to either focus on a particular industry or diversify by buying hundreds of different securities with one purchase.

However, a good friend of mine, Ryan Rupert of Morgan Stanley, recently wrote a very interesting piece on the dangers of these index securities. At first I was very skeptical of arguments against ETFs. How could they be harmful? But after pondering his analysis, I began to see how there could be a problem with owning index funds as they gain in popularity.

To understand Ryan’s well thought- out arguments, it helps to take an extreme example. Let’s imagine that index funds become more and more popular until they dominate the market- place and push out all actively managed funds like hedge funds. Now let’s say in this scenario, on a particular day, investors want more exposure to the market on a day where Apple reports poor earnings. The new money being put into the market goes to the index fund where the fund manager has no choice but to buy Apple because she has to buy the index and Apple makes up a significant part of the index. So, in this case Apple stock would go up even though they miss earnings.

The point of the argument is that index funds distort stock valuations. The fund manager has no ability to buy or sell stocks based on earnings, management or market opportunities. In a world dominated by index ETFs, a biotech company that suddenly developed the cure for cancer would not see any movement in its stock price. Or a company like Sears, which used to be the largest retailer in the U.S., would continue to attract capital — passive funds would be forced to buy it because the company historically was a large component of the retail index.

Beyond distorting stock valuations, index funds really go against the basic tenets of capitalism. Capital markets exist to funnel needed capital to the places where it is needed and can be rewarded. That means money should flow to successful companies and be siphoned away from unsuccessful ones. However, index funds don’t care about the success of companies; they only allocate capital according to index weighting.

So does this mean I advise selling index funds and putting money with actively managed ones, or buying individual stocks? For me, I am sticking with my ETFs for the time being, for one main reason. I do not have the expertise to select active funds or managers that can outperform the market in the long run, after expensive fees. The same goes for stocks. I just don’t have the time or information to research individual stocks to know which will outperform the market.

That being said, ironically, it is people like me — and the success of index funds — which actually make active funds more and more appealing. The more these passive funds attract capital, the more distorted stock valuations become and thus greater opportunities for stock pickers and active money managers.

This also means that in a market sell- off when investors are liquidating index funds, the stocks that make up a large portion of these funds, like Apple and Google, will be punished down beyond reason. Funds will be selling these high-quality stocks even if they don’t deserve to be sold. In this case, it may make sense to buy these names.

For now, I am sticking with my low- cost ETFs. But as market volatility increases, it will be interesting to see if these securities retain their popularity or if active management becomes more popular once again. Q

— Eric Bretan, the co-owner of Rick’s Estate & Jewelry Buyers in Punta Gorda, was a senior derivatives marketer and investment banker for more than 15 years at several global banks.

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