Warren Buffett, the billionaire investor and chief executive of Berkshire Hathaway Inc., recommended that mom-and-pop investors put their money into index funds as a way to achieve a key goal of asset allocation: diversification among broad categories of companies and industries.
But index investing is reinforcing distortions in the market, making it a risky strategy, writes Daniel Godfrey, co-founder of The People’s Trust, an investment trust.
“Setting indices as benchmarks for active funds has led to hugely negative consequences because it has corrupted the purpose of investment,” he says in the Financial Times. “Index-benchmarked, tracking-error controlled investment management, which accounts for tens of trillions of dollars globally, needs to be replaced by patient, long-term, high-conviction, high stewardship investment.”
Passive investment strategies of putting money into exchange-traded funds that seek to match the movements of a market index have become more popular than active fund management, which tends to have costlier fees, higher risk and spotty performance. The SPDR S&P 500 ETF is a fund that trades like a stock, for example, but gives investors exposure to the entire index of the biggest U.S. companies.
Godfrey recommends making investments on convictions about a company’s prospects to create wealth, and the proper management toward meeting that long-term goal.
“The purpose of investment could be defined as sustainable wealth creation. Success delivers long-term absolute returns to investors,” he writes. “But it also drives investment in human capital, leading to better jobs, supply chains, innovation, research and development, and new products. It promotes care for local communities and the environment. It will ensure focus on corporate reputation in areas such as pay inequality, tax and lobbying.”
In the past year, the market’s performance has driven by a handful of stocks, such as the so-called “FAANG” companies that also boast strong sales or earnings growth: Facebook, Amazon, Apple, Netflix and Google (whose parent company is Alphabet). Index funds keep buying those stocks to match their weighting in indexes like the S&P 500 or Nasdaq Composite.
The problem with indexing is that it doesn’t diversify an investor’s holdings when the index is so distorted by the performance a handful of large companies. If one of those companies makes a misstep, it will have an outside effect on the index and any fund whose performance is tied to it.
Meanwhile, Vanguard Group Inc. Chief Executive Officer Bill McNabb reportedly doesn’t consider the explosive growth of exchange-traded funds (ETF) as a systemic threat or fuel for a stock-market bubble.
McNabb told the Financial Times that index-tracking funds, which includes the $4 trillion invested in ETFs, represent much less than 15 percent of the equity market capitalization around the world. He said index-tracking funds accounted for less than 5 percent of daily trading volumes of global financial markets.
“I don’t see the bubble,” McNabb told the FT. “The data belie the fears,” he said.
“I don’t think what is happening in ETFs is systemic,” said McNabb. “The concerns are more specific and idiosyncratic.”
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