You might be familiar with the trend called “index investing.” Exchange Traded Funds (ETF), or Index Funds, are forms of investing that reject the notion of choosing individual stocks in favor of “owning the whole market,” so to speak. They came about because statistics showed that the average actively managed mutual fund consistently underperformed the index against which its performance was measured. So, the logic was simple: just buy the whole market (or index(s) of your choice that represent different segments of the market) and forget about it.
This means you take all the decision-making out of the equation and just buy every stock in the basket, or index. By buying every stock in the index, you are assured a certain level of diversification or the lack of risk in individual businesses that you are exposed to if you own concentrated positions. This is a good thing. Your investment just mimics the index. It is also cheap. There is no “Oz behind the curtain” charging anything for its work in an index fund. There is only the cost of the index sponsor.
Vanguard rose to fame doing things this way as a response to mutual fund managers charging an arm and a leg and not outperforming their respective index benchmarks. It was considered the great leap forward for average (and professional) investors. What was once considered unorthodox is now the accepted wisdom. Today, almost everyone is doing it. It is ubiquitous among retail investors and 401(k) plans and is strongly promoted by the media. In fact, today it is likely that your neighbor anywhere in the country would happily tell you the solution to retirement is buying an index fund and calling it a day. However, this begs some larger questions as to why this strategy has worked in the past, and whether it will continue to work in the future.
Index investing is a copycat strategy. It fundamentally relies on other more discerning styles of investment to do its dirty work, so it can stay cheap. Indexes are constructed around one central criterion each – be it size, industry, or yield. To be included in an index, a company must meet that single criterion and nothing more. This worked well early on because there was plenty of non-indexed money to do the work — what is known as “price discovery.” This is the process of evaluating a security to see if its price makes any sense at all fundamentally and trading it, voting it, and influencing it one way or the other to return it to its normal and deserved price. This is necessary so that the stocks of companies included in an index deserve to be there based on the actual performance of their operations. The idea was that, with many people doing such “price discovery,” the market could be considered efficient and there would be no distortions in the proper price of a security at any time. If you take away that “discovery” process, and have everyone just buying everything willy-nilly via an index, the efficiency on which the strategy of indexing was based begins to deteriorate.
According to a recent article in Bloomberg Businessweek, the big three firms that sponsor index investing products, Blackrock (iShares), Vanguard, and State Street (SPDR), have about $15.5 TRILLION invested in their index funds, and the number is growing. With no end in sight to its adoption, index investing will eventually mean that the vast majority of invested dollars will be, to put it bluntly, lazy and blind.
The Bloomberg Businessweek article highlights this issue more in depth and includes this cautionary excerpt: “even Vanguard founder Jack Bogle—a tireless advocate for indexing—warned just before his death in January 2019 that there may be too many shares in too few hands. Index funds are so successful, he wrote in the Wall Street Journal, that they could one day effectively control the U.S. stock market. ‘I do not believe that such concentration would serve the national interest,’ he said.”
At Chicory Wealth, what is also central to our philosophy of investing, in addition to return, is the issue of good corporate behavior and what is now known as ESG (environmental, social, and governance) metrics. We are realizing as a society that we are on an unsustainable path for the planet. The most obvious way to make incremental change in this area is to influence the way companies produce the goods and services they sell. We believe that by selling the stock of companies doing worse in these areas and buying the stock of companies doing a better job, in conjunction with underlying financial strength and performance, we are not only participating in this change, but are enhancing the value of our clients’ portfolios. Companies that care about these metrics do better, over time, than companies that do not. An index investment also does none of this. If a stock meets the single criterion for being included in the index, then the investment is buying that stock without a second look at any other criteria — financial, environmental, or otherwise.
So, what can we (and you!) do about this situation? For starters, at Chicory Wealth we are adopting a policy of “knowing what we own” on behalf of our clients and moving away from the use of index funds in general. While we were early adopters on the index fund trend, we no longer feel it is in our clients’ interest to use this strategy. Instead, we are continuing to invest in companies according to their financial strength and their stewardship of the world and its shared resources. We are engaged in shareholder activism to help these companies get better in terms of their environmental, social, and governance metrics over time. And we actively monitor these metrics, both fundamental and ESG, to help maintain the highest possible quality of holdings on behalf of our clients. This is just one of the ways we are making good on our brand promise: “Integrating Money and Meaning.”
Photo above by Frank Busch from Unsplash.