Why use index funds?

- Fritz J de Boer, CFP, NZIJ Financial Services Limited


The problem is that index funds are always aligned to an index of one sort or another as a proxy for the “market” or a part of it. The problem is that the indices are continuously adjusted based on the stocks that each index tracks. For each index, stocks will either be added or removed when these adjustments are made to reflect the “current” weighting of these stocks in the market the index tracks. This means that the composition of the index may be quite different from one year to the next.

The argument for using index funds is that they represent the market and a bit of academic nonsense known as “Efficient Market Hypothesis” (EMH) says that we humans cannot beat the market. In short, the idea behind the EMH is that you and I cannot ever beat the market in the long run.

The EMH portrays a stock market where every bit of news about a stock is priced into the stock immediately. That’s why - supposedly - none of us can discover anything fast enough to give us an advantage or any way to beat the market over time. The academics base the EMH and their disdain for our abilities on a gazillion studies that they say prove the EMH by comparing the results of different stock-picking systems to “the market.”  And “the market” is – yes, you guessed it - one of those indices put together by a bunch of humans.

To put this in perspective, humans cannot choose stocks that beat the market when choosing stocks for their own portfolios. However, humans who join committees can choose superior market-setting stocks when they are selecting candidates for market indices.

This is only one of the many faults with the EMH. And, I might add, it’s a major fault - because certain humans don’t do such a great job picking index stocks, either. The Dow is a case in point where this month the Dow committee has spoken. Two current Dow stocks - Altria Group and Honeywell - come out of the Dow Jones Industrial Index. In their place the Dow Jones board has decided to add Bank of America and Chevron.
 
This shakeup looks a bit strange. The Dow already has four financial stocks - JP Morgan, Citigroup, AIG, and American Express. It needs more? That’s the official line. But one could argue that there is already a fifth financial they’re forgetting to count -   GE - because 19 percent of GE’s revenues are from its Commercial Finance and Money Divisions. By market cap, that makes GE’s finance segment as big as American Express. In the energy department, the Dow already has ExxonMobil, the world’s largest oil company by market cap. Chevron makes two.

The rationale for the current shakeup is that the US economy has more financials than the Dow did.  That explains Bank of America.  The US economy has been top-heavy with financials for decades. Why add Bank of America now? In fact, why add it after financial stocks had their big run? Maybe because it’s so cheap, the Dow board can be fairly sure it’s going to go up over the next five years or so?

The current changes don’t change one thing, though. This still isn’t a very “industrial” index. The industrials are only 22 percent of the current Dow Jones Industrial Index.

Assuming that, as EMH claims, we do all have access to all the market information about a stock, what we do with that information and how we interpret it will impact on our decision making. And that is likely to be different depending on our own perspective of the importance of particular information.

In summary, while human beings are allowed to select what goes into the various indices, the indices will continue to be a poor reflection of the “Market”. Accordingly, I would choose an actively managed fund, managed by a competent team of investment professionals with an excellent understanding of the respective market, over an index fund any day.