Last week, I spoke at the Mississippi CFA Society’s annual forecasting event. It was one of the most pleasurable events I have attended. Don’t believe the negative hype on Mississippi. It’s an amazing place, and I would live there in a second. I am not kidding.

One of the things we talked about on the panel discussion was indexing. I can’t remember specifics, but I’ve probably talked about indexing in The 10^th Man before. It is a bomb. Or more like a slow-moving electromagnetic pulse. Right now, 56% of all stock market assets in the US are passive, up from 50% a few years ago and up from 2% in 1999. In Japan, over 70% of all stock market assets are indexed.

You’ve probably heard a lot of active managers complaining about how hard it is to beat the index these days. It’s difficult to explain the mathematics behind it, even in terms a layman would understand, but just know the more the market is indexed, the harder it gets to beat the index. Which naturally increases the incentive to passively invest.

This is why I call indexing a bomb. Vanguard is a bomb. The more assets Vanguard gets, the more it lowers its fees, which encourages more people to send their money to Vanguard, which results in more money under passive management. It’s a self-reinforcing process that is not going to stop until the entire market is passive. And then what? What will happen next, when everyone owns an S&P 500 index fund? You basically own pure beta, and all the diversification benefits disappear. They have already disappeared.

Volatility

One thing I like to point out to people is this:

When you invest in an index, you get the return of the index, but you also get the volatility of the index.

A lot of people like the returns of the index—you beat active managers over 99% of the time on a 10-year basis, or something like that. But the returns come with volatility. You may be getting the return of the S&P 500, but you are also getting the volatility of the S&P 500. And the S&P 500 is pretty volatile! It moves, on average, a little more than 1% a day, or up to 20% a year. That’s a lot for your retirement savings to move around. Americans don’t think about that much. Stocks go up over time, right? Just dollar-cost average and invest for the long run, and everything will work out.

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But over any 40-year investing career, there will be one, two, maybe three 50% drawdowns. And as much as you believe in stocks for the long run, it is difficult to maintain that faith in large drawdowns and in periods of huge volatility. So, good financial advisors will try to mitigate that volatility by investing across sizes, styles, and different asset classes. This is the point that I was trying to make to the Mississippi CFAs. I’m not sure it got across.

I should also point out that at one point in history, the S&P 500 went down 89%. I don’t care who you are—nobody can withstand an 89% drawdown. Of course, the market did come back… 17 years later. Can you wait that long? What if you’re 62 and planning to retire at age 66, but the market goes down 89% in four years? What then? Are you sure you want to have all your assets in the S&P 500?

I deal with these people all the time. Bogleheads. You cannot invest in the stock market for any length of time without considering the behavioral consequences.

It Wasn’t Always This Hard

I’m old enough to remember a time when investing was easy, when complete knucklehead portfolio managers used to sit back and collect fees for shadow indexing. There have been a lot of price pressures in the mutual fund industry, and it is getting harder and harder to compete. I would say that this is better for consumers in the long run—after all, the fees on some of these index funds are a mere four basis points—but all we’ve succeeded in doing is driving people into portfolios with pure undiversifiable market risk.

Remember, in 1999, an S&P 500 index fund did offer diversification benefits. You owned 500 stocks. But when everyone owns the same 500 stocks, there are no diversification benefits. It’s essentially as if all investors were piled into one stock. And the way to make money in a stock when everyone owns it is to buy before everyone else does and sell before everyone else does. In a sense, we’ve turned everyone into market timers, which was not the intention.

There is a lot more to say here, but this is a good place to stop. You probably think your index funds are the safest things you own. Think again.

In the meantime, if you haven’t seen it, check out the conversation between Keith Fitz-Gerald and Ed D'Agostino. Keith discusses his approach to volatile markets, diversification, what the Fed could do next, and a variety of other topics. My partners tell me the video won't be available beyond this weekend, so watch now by clicking here.

Jared Dillian

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