Which Index Funds?

Portfolio manager’s Letter September 2003

Many investment managers recommend that investors should purchase Index funds such the ones based on the S&P 500 index. Proponents of the “Efficient Market Theory” say that since the market is efficient it is impossible to beat the market, so the best thing to do is buy the whole Market by investing in the index funds. OK, but, which index funds?

Ten years ago the answer to this question seemed easy. Index fund meant the Vanguard S&P 500 Index Fund. But today we have a world economy with tens of thousands of different companies publicly traded on many different stock markets; an index of 500 American Companies can hardly represent the broad range of the world economy.

In truth, today any fund based on the S&P 500 is a sector fund that represents mostly over priced American large cap stocks. As Sectors go this one is really a dog. Because the Index is weighted based on Capitalization it basically tracks the adventures of the 50 largest companies in this Country. To make matters worse, Berkshire Hathaway, the only one of the fifty biggest American companies that is currently worth buying, is not even in the S&P 500. It is my current opinion that funds based on this index are likely to under perform small and mid cap indexes in this country, many developing country indexes for the next ten to fifteen years.

In his book Beyond Greed and Fear, Hersh Shefrin describes what he calls The Gamblers Fallacy. This is the tendency of strategists to misinterpret the rule of “reversion to the mean”. Since the S&P 500 has returned something like 10% per year for the last 100 years. A reversion to the mean suggests that eventually it will provide us 10% per year for the next 100 years. Yes, the economy will recover as it always does, and the world economy will grow for the next 100 years, but I see no Guarantee that large American companies will participate in that growth to the same degree that they did in the Twentieth Century.

Jim Rogers says that while Nineteenth Century was the “British Century” and the Twentieth Century was the “American Century”, the Twenty-first Century will be the “Chinese Century”. I am not sure I agree with this forecast, but a mindless assumption that large American companies will continue to dominate the world economy for the next ten, twenty, or thirty years is not necessarily warranted by either history or current economic trends.

The following list will give you some idea of the type indexes that can be tracked today, but this list is contains only a faction of all the different ways there are to track indexes today, and more choices are being added almost daily.

Global Index Funds

iShares S&P 500 index fund

iShares S&P global 100 index fund

iShares S&P global energy sector index fund

iShares S&P global financials sector index fund

iShares S&P global healthcare sector index fund

iShares S&P global technology sector index fund

iShares S&P global telecommunications sector index fund

iShares S&P Europe 350 index fund

iShares S&P/tse 60 index fund

iShares S&P Latin America 40 index fund

iShares S&P/topix 150 index fund

iShares NASDAQ biotechnology index fund

Dow Jones Index Funds

Dow Jones U.S. Basic Materials Sector Index Fund – IYM

Dow Jones U.S. Consumer Cyclical Sector Index Fund – IYC

Dow Jones U.S. Consumer Non-Cyclical Sector Index Fund – IYK

Dow Jones U.S. Energy Sector Index Fund – IYE

Dow Jones U.S. Financial Sector Index Fund – IYF

Dow Jones U.S. Financial Services Index Fund – IYG

Dow Jones U.S. Healthcare Sector Index Fund – IYH

Dow Jones U.S. Industrial Sector Index Fund – IYJ

Dow Jones U.S. Real Estate Index Fund – IYR

Dow Jones U.S. Technology Sector Index Fund – IYW

Dow Jones U.S. Telecommunications Sector Index Fund – IYZ

Dow Jones U.S. Total Market Index Fund – IYY

Dow Jones U.S. Utilities Sector Index Fund – IDU

Morgan Stanley International Index Funds

EWAMSCI – Australia Index Fund

EWKMSCI – Belgium Index Fund

EWZMSCI – Brazil Index Fund

EWCMSCI – Canada Index Fund

EFAMSCI – EAFE Index Fund

EEMMSCI – Emerging Markets Index Fund

EZUMSCI – EMU Index Fund

EWQMSCI – France Index Fund

EWGMSCI – Germany Index Fund

EWHMSCI – Hong Kong Index Fund

EWIMSCI – Italy Index Fund

EWJMSCI – Japan Index Fund

EWMMSCI – Malaysia Index Fund

EWWMSCI – Mexico Index Fund

EWNMSCI – Netherlands Index Fund

EPPMSCI – Pacific ex-Japan Index Fund

EWSMSCI – Singapore Index Fund

EZAMSCI – South Africa Index Fund

EWYMSCI – South Korea Index Fund

EWPMSCI – Spain Index Fund

EWDMSCI – Sweden Index Fund

EWLMSCI – Switzerland Index Fund

EWTMSCI – Taiwan Index Fund

EWUMSCI – United Kingdom Index Fund

This list of index funds is very limited, but you get the idea. There are hundreds (maybe thousands) of index funds and they are all basically sector funds. Some of these index funds will return something close to the returns of the S&P 500 during the twentieth Century, some will do better, some will do worse, but if you know which is which, you are a lot smarter than I am.

Sector Bets

My objection is not to index funds per se, but to the notion that there is one particular index fund that represents the over all market, and that purchase of such and index is a one decision investment that can be bought and cherished forever. This may have been a workable assumption ten years ago, when there where only one or two index funds that mattered, but not today.

Because of the Globalization of the world economy and the rapid expansion of its capital markets, Indexes have sprung up all over the world. These indexes and the funds that track them are basically sector funds tracking the performance of a national market, or some sector within a national market. Today, Index investing is basically placing a sector bet.

I have nothing against sector investing, there may times and places where sector funds can be helpful investment tools, such as when investing in countries other than the US were many securities are not available to US investors. But sector bets should be recognized for what they are. And they are not necessarily the best choice for inexperienced investors.

Even if you choose an index fund using broad based index like the Wilshire 5000 You are still making a sector bet on American Companies and ignoring the rest of the world. Foreign Equities have not been good investments for the last ten years as capital from all over the world has flowed into large cap American companies, but now there is a valuation gap between the US and the rest of the world.

In addition to this valuation gap, there are a lot of countries in Asia, Latin America, and Eastern Europe where future GDP growth may come a lot easier than it will in the mature economies of US and Western Europe. I have no idea how all this will work out, but telling someone to put all their money in a S&P 500 index fund and forget about it, is not my idea of doing them a favor.

Capital Allocation

Intellectually I object to index funds because they support massive misallocation of Capital. The function of the capital markets should be to allocate capital to companies that use it most efficiently, but the popularity of indexing in the 1990’s caused money to flow into the stocks of Large cap American Companies with no regard to whether those companies were able to use the capital effectively. There a nice irony here. The more popular that indexing become the more it was prone to creating inefficiencies in the capital markets. The indexing tide raises all boats in the index without regard to the intrinsic value of the boat.

The money flowed in; raising the value of the companies in the index (and the relative performance of the index funds) till the stocks became over valued relative to stocks that were not in the average. The inevitable result was our present period where the stocks in the index are under performing the stocks that are not in the index. It seems to me that all future Index investing will experience a similar pattern, as an index becomes popular the companies within that index will become overvalued and a correction will follow.

Mr. Market is still bipolar, and the prudent investor will sell to him when the investor feels his stock, (or index) is overvalued, and buy from him only when what Mr. Market is selling is under valued.

The easy money from rising stock prices eventually produces all kinds of bad behavior. It finances capital spending for expansion projects where the projected demand never materializes. It produces countless mergers where the only real motivation is CEO ego gratification.

Even today, many of the largest companies in the S&P 500 remain over valued and with a considerable mess left to clean up. The corrective process may take years. Look at the Nifty Fifty of the Nineteen Seventies, some of those companies never recovered from the mistakes they made in the sixties and seventies and for the ones that did recover it was a long process. In Japan the correction has been going on for twelve years and stock market is still in the tank.

Finally, there is no way to learn about investing if you are not participating. The best education comes from the mistakes that you make and research you do. You are never going to learn about valuation if you do not buy stocks. For capital markets to work properly, and send capital to companies that can use it efficiently, we need more educated investors, not passive participants.