January 23, 2019
Vanguard Fund founder Jack Bogle died last week. He was the champion of rookie investors everywhere by designing and inventing the first “index fund” back in 1975. No longer did beginning investors have to buy 10 or more individual stock names, at ridiculous brokerage fees, to acquire a balanced portfolio. He launched the fore-runner of his Vanguard Index Fund on December 31, 1975. The timing was fortuitous.
When the stock market peaked in early 1973 and then suffered a long two-year descent, many “Nifty 50” stocks tanked, so the idea of a “broad market index fund” arose, first as a theoretical idea in a popular book by Burton Malkiel, called “A Random Walk Down Wall Street.” In the book, Malkiel fantasized:
“What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch winners….Such a fund is much needed, and if the New York Stock Exchange (which incidentally has considered such a fund) is unwilling to do it, I hope some other institution will.”
That “other institution” became Vanguard Funds, founded in 1975 by Jack Bogle, who had recently been fired by Wellington Management Co. He launched the First Index Investment Trust (later renamed the Vanguard 500 Index Fund) on December 31, 1975. As a result of his untiring efforts since then, plus a long bull market (1982-99) delivering gigantic returns, Vanguard is now the largest mutual fund company in America, by far. At last count, Vanguard controls $3.8 trillion in assets under management (AUM), or about 20% of the $19 trillion placed in mutual funds, far ahead of #2 Fidelity, at $2.1 trillion in AUM.
Then came ETFs. During this week in 1993, the index fund turned into a potential Frankenstein monster when the first index Exchange-Traded Fund (ETF) arrived on January 22, 1993. That’s when State Street Global Investors released its S&P 500 Trust (SPDR, or “spider” for short). With ETFs, investors don’t need to wait for end-of-day settlement price, as with mutual funds. They can trade ETFs during the day.
That’s when Jack Bogle’s egalitarian “index fund” turned into a potential Frankenstein monster. Now, the SPY ETF is not just owned by the “little guy” in trainer wheels. Massive institutions with algorithmic formulas for darting in and out of the market in nano-seconds use SPY, leaving market chaos in its wake.
As Louis Navellier and Jason Bodner have been pointing out here for several months now, ETFs can trade at steep premiums and discounts to NAV, thereby fleecing small traders. ETFs can also fail to accurately track their benchmark in “flash crashes” or deep crashes, or during wicked volatility days such as what we saw last December.
As of the end of 2018, the four biggest funds are index funds led by the S&P ETF, followed by Vanguard:
This trend has continued through the end of 2018. Last Wednesday, the day Jack Bogle died (January 16), Morningstar reported that actively-managed funds suffered huge net outflows of nearly $143 billion in December – their worst month ever – and -$301 billion in net outflows for the full year 2018.
Morningstar analyst Kevin McDevitt said that actively-managed “large-growth and large-value funds continue to get hit the hardest.” In December, investors fled to cheaper passive strategies. Index funds reeled in nearly $60 billion in December alone. Investors have seemingly thrown in the towel on stock-picking or managed funds: “I’ll just buy ‘the whole market’ and admit I’m powerless to beat the index!”
Index funds are still ideal for beginners with only a few thousand dollars to invest. For the last six years, for instance, I have been Board President of a local historical society and an index fund is the only kind of stock investment where I can get board approval. Nobody wants to “speculate,” and index funds feel safe.
But in my personal life, I have never invested in index funds. I have been a stock investor, following the lead of analysts I trust, like Louis Navellier. I would never aspire to be “average.” It seems un-American. What kind of American dreams of being a “C” student, sitting on the junior varsity bench in high school and then majoring in finance, settling into suburbia with 2.3 children, and getting into his “driverless car” to commute into a big box building where his job is to add or subtract stocks for some index fund?
Investing in highly-popular “index” funds is like seeking a guaranteed “C” average. That might work in egalitarian Europe but not in entrepreneurial America. More to the point, investing in these somewhat-manipulated big-cap averages can – at times (like 2000 or 2008) – be dangerous to your financial health.
Real Investors Don’t Cap-Weight Their Portfolios
One big problem with index funds is that they are “cap-weighted,” so that huge mega-stocks (like the FAANG stocks) can dominate the index. This can lead to some serious overweighting near market peaks:
- In early 2000, about 50% of the S&P 500 index was in high-cap tech stocks.
- In early 2008, about 40% of the S&P 500 index was in high-flying financial stocks.
In real life stock-picking, investors don’t “cap-weight” their portfolios. If I owned five stocks of various cap sizes, for instance, I wouldn’t put 90% in the biggest stock. I would try to own roughly equal amounts of each, at least in the beginning. Obviously, small stocks have more room to grow, although they might also be more volatile, whereas a $500 billion stock has less room to double. Personally, I prefer “mid-cap” stocks – the “Goldilocks” middle – companies with proven track records but with room to grow.
Imagine you had $555,550 to invest in five stocks in a cap-weighed manner, like the S&P 500. Using cap-weights, you would have to put 90% in one stock, thereby creating a warped portfolio like this:
If I had five stocks in mind, and they had that wide a variety of market size, I might put 30% of my total available funds into the sturdiest, most conservative pick (maybe large-cap), then 25% in the mid-cap, 20% in mega-cap and 10% to 15% in the more speculative smaller stocks. I would never consider putting 90% into one stock, 9% in another, and 1% in the rest. That doesn’t make sense in your personal portfolio, and it doesn’t make sense in the large (multi-trillion dollar) arena of the aggregated index funds, either.
By cap-weighting, today’s index funds have more-or-less created a new “Nifty 50” all over again – like the “go-go” early 1970s. In this way, a cap-weighted index is riskier than prudent stock picking. We live in a real world that continues to reward the most prescient investors and analysts – not just the robots.