What does Jack Bogle, Jeff Gundlach and… GMGH have in common?!
How about all of us being geniuses? (haha, I'm just kidding about myself)
Okay, so what is it that we really have in common? Well, it's that while we all think index investing is wonderful, there are limits to it being a forever successful strategy.
Don't get me wrong. Don't get triggered so fast.
I own ETFs and I think that indexing is a very decent strategy for most people. However, there is NO strategy that is infallible. There is no holy grail investment with low/no risks and high returns. There are obviously some strategies that are better than others (value, growth, momentum, etc) and some which are worse than others (buying stocks that start with a certain alphabet, or based on your horoscope). Index investing falls into the category of the "better strategies", but that is not to say that indexing is perfect, meant for everyone, in every situation, all the time.
One of the things that irks me is the fact that almost no one ever talks about the risks and problems about indexing.
Yes, even Jack Bogle, the freaking guy that started Vanguard, one of, if not, the biggest asset managers in the world (couple trillion AUM) that is literally built upon indexing, has said that indexing has a limit. The same limit that I mentioned 3 years ago - the problem if everyone starts indexing.
With 25% of the US market already indexed, and growing, the financial markets are steadily marching to a world where everyone becomes a freeloader and hopes for average market returns. Of course, you wouldn't need to be a professional freeloader to know that if more people are freeloading than contributing... it doesn't work out. Price discovery breaks down and the net worth of countless of people can be pushed around on a daily basis by the remaining and actual market participants.
Gundlach is even more critical of index investing, but his points are absolutely valid. Indexes are still created upon a set of rules that someone has come up with. The only difference is that a computer follows those rules without question, while the human that created those rules, can choose to follow or break those rules, and also charges a more expensive fee.
However, his point isn't about the more expensive fees. His point is about how indexes are still subject to human creation and influence, which means that managers can still decide which stocks to include and exclude from an index, and in what amounts...... HEY WAIT A MINUTE, THAT SOUNDS LIKE ACTIVE MANAGEMENT.
Because it is.
Really, the only differences is the fees. Which is fine if your main argument is that ETFs are cheaper, and that is the main reason for the outperformance over traditional active managers. Basically, you have to think that indexing performs well because of the savings in management fees, not because the index includes, excludes or allocates to stocks better than active manager. The index itself neither gives nor has an special magical powers to generate superior returns.
When investors decide to index, THEY STILL HAVE TO PICK THE INDEXES AND THE ALLOCATION.
It's one layer above stock picking within the index, but it still requires active decision making. Do I want to have emerging markets exposure? Which countries / continents / currencies do I want to avoid and which ones do I want to overweight? What asset classes should I be in? Hey, isn't that a commodity index? Should I also have commodities?
If you think that by deciding a few years ago to only invest in 1 ETF *COUGH COUGH STI ETF COUGH COUGH* and that is called passive investing and it's a super solid strategy to weather all conditions, you might want to really think if that particular index is right for you.
Sure, investing solely in the STI ETF is still indexing. But so is choosing to buy an ETF that follows the index of diseased livestock.
ETFs don't magically make risks disappear. They reduce unsystematic risks based on number of holdings in the index and the allocation to them, but they hold plenty of systematic risks. And that right there is the biggest issue I have about people anyhow promoting indexing. They say all the good stuff and gloss over or leave out any of the bad stuff.
Indexing is a decent strategy. To get to the point where the majority of the market is indexed is still some ways out in the future, which is a different problem to deal with for a different time. However, let it be known that there are risks involved in indexing investing.