5 Reasons Index Funds May Be Bad for America

Jeremy Schneider: Welcome to the Stay Wealthy podcast with Taylor Schulte. As you may be noticing, this is not Taylor Schulte. This is Jeremy Schneider filling in for Taylor for the month of June and I'm recording these episodes a few weeks in advance.

And I just heard Taylor's most recent episode where he shared publicly that he's indeed having a baby this month, which I think is the real reason why I'm taking over for the month of June. So he's having his third kid in between his successful business and his podcast and writing all the articles and emails and everything else that he does.

I'm sure the third child will keep him busy. So send Taylor your congrats. You can find the show notes and links that I mentioned in this episode at youstaywealthy.com/113.

So the title of this episode, Five Reasons Index Funds May Be Bad For America, is kind of click baity. But the reason I'm talking about this is because index funds are super popular.

The first one, if we look back historically was actually introduced not that long ago, back in 1975 by Jack Bogle, the founder of Vanguard and his idea of having an index fund that basically instead of carefully choosing which stocks to buy to maximize your performance, his idea of an index fund was just to buy all the stocks to just guarantee your fair share of growth of the entire stock market for a while.

That basically made him the laughing stock of the industry. You know, these Wall Street guys who their entire business was around choosing stocks and doing fundamental analysis and really diving deep into which stocks are good and which stocks are bad.

His idea that you could just buy all the stocks was kind of ridiculous at the time, and he was, was made fun of and it was relatively a slow start too, but times they've changed.

In fact, in the year 2016, if we fast forward about 40 years after his first introduction in 2016, investors were pulling out $300 billion a year from actively managed mutual funds and putting 500 billion into passively managed index funds. And so by 2016 there's this like big shift happening. And then by 2019, index funds have actually passed.

Actively managed funds is having more invested money as of today in 2021, there is significantly more money being invested and being held in index funds as compared to actively managed mutual funds. And when something has a meteoric rise to success or rise to fame, as index funds have done, it undoubtedly and unquestionably becomes the focus of attack and index funds are no different.

And I'm a fan of index funds by the way. I personally invest in index funds full disclosure, with basically all of my equities that I invest in. But I often have people who point me to some articles and I know there's kind of like a negative article about index funds. They point me to those article and say, what about this?

And so in this episode I'm gonna basically talk about a few of those articles. I've kind of combined them into one podcast here and try to make an honest case for the points that they make in those arguments. And then I'll give my counterpoints based on my perspective of the world.

So these articles that I'm gonna talk about are in the show notes by the way, at youstaywealthy.com/113.

One of the articles is called Has Passive Investing Become Fraught With Risk? That was published in US News World Report. Another one was called Could Index Funds Be Worse Than Marxism? And that was published in The Atlantic.

And so if you're accusing me of having a clickbait article on this podcast, how about that for clickbait? And I also did utilize another article called The Misplaced Attack on index funds that was published in Morningstar.

So one of these articles is basically an interview with Michael Burry. He's the guy who is famously one of the few to predict the 2007 housing crash. And he was also even more famously portrayed by Christian Bale in the movie The Big Short. And whenever there is a financial expert who gets a big bet, right, they kind of become like the media darling for all their, you know, future bets.

And Michael Bur is maybe the most clear example of this, but it happens pretty regularly with other financial experts too. And so in this article, he basically used the word index fund and bubble in the same sentence. And so then you know that that article got a whole lot of traction.

And so I'm gonna break down five different reasons or five different arguments against index funds and five different reasons that index funds might be a problem either for the American economy or for, you know, individual investors. So here it comes.

Problem number one, no price discovery leads to an inefficient market. And so this is the original problem with index funds, as pointed out by all of Jack Bogle's competitors, was that it's not smart money. You know, it's not, you're not individually deciding which stocks to buy, not buy, you're just putting all the money in.

So this problem still exists to this day and Michael Bur pointed us out and he basically says it can inflate prices if you're just paying anything for all the stocks, it can put all the prices up. In fact, his quote was quote, This is very much like the bubble in synthetic asset backed CDOs before the great financial crisis in that price setting in that market was not done by fundamental security level analysis, but by massive capital flows.

So he's basically saying, you know, back then people weren't carefully looking at these individual securities, they were just putting blind money into it. And he's saying that's the same thing that's happening in index funds.

Another symptom of this might be that all prices move together instead of individual securities or individual stocks being priced separately, right? So if everyone's just putting their money into index funds, every price goes up at the same time when people pull their money out, all the prices go down at the same time. And we largely rely on what we consider to be an efficient and liquid market.

And so when, if this were, you know, if this bad thing were to happen where the market is no longer efficient, it's no longer a liquid, all the prices are moving together in lockstep, that would be bad for individual investors. You know, it could cause dramatic crashes or you know, inability to get your investment out at market rate, etc.

But here's my retort to that is that when there is an inefficiency in the market, I'll be the first in line to take advantage of it, right? If it's really true that, you know, this lack of price discovery is moving stock prices unfairly or incorrectly, I'll be the first one to like go short sell one stock and buy another stock. You know, when I can predictively do that with like a lot of confidence, I would love to make more than the stock market returns.

I would love to have alpha, right? That's a return above what the stock market returns. And I'm not alone, you know, I'm probably not very near the front of that line. There's people doing that all the time. There are hedge funds, there are algorithmic traders, there are actively managed mutual funds which still manage, you know, trillions of dollars. And even though they're smaller than index funds, they're still huge. There are day traders, all of those entities agree that they would love to get some alpha.

And so even though there's a lot of money in the index funds, there's also a lot of price discovery still happening. I'd also point out that, you know, what happened in 2007 was an anomaly. That crash that Michael Brewery called when the, you know, the CDOs were having dumb money pumped in was, was strange because basically, you know, no one had ever seen the real estate market crash like that before.

And so no one was really aware of that type of thing happening. But now they are because as in the past, and the thing about, you know, past history is that it gets priced into the current markets, right?

And so when Michael Brewery is saying this is a bubble that could pop, people know now that unexpected bubbles may pop. And I would say that is now being priced in and that is creating more liquidity in the market because people might be betting on that and be trading individual stocks or betting against, you know, the things that could cause this bubble to happen. And with regard to the market moving together, there's no real evidence for that.

In fact, according to data compiled by Amundi research, the correlation among the s and p 500 stocks has remained steady since 1974. You know, the year before index funds were even brought to market by Jack Bogel.

And a lot of these, by the way, a lot of these problems, there's not a lot of real concrete evidence. It's more like this might be a problem going forward. But for now, problem number one, no price discovery for me. I'm living my money in index funds.

All right, problem number two, lack of liquidity. So in the first quarter of 2019, Vanguard enjoyed net inflows of 62 billion. But Berg in this article pointed out that 266 of the 500 stocks in the S&P 500 had less than 150 million in trading that day. And so, as he said, the theater keeps getting more crowded, but the exit doors are the same as they always were.

So he's basically saying, you know, we keep putting more and more money in, but when we pulled out, there might not be enough liquidity. You know, if you're, and for maybe huge companies, this won't be a problem, but for small companies, there just might not be enough sellers in the market to provide liquidity for people to get their money out when they want it.

And when that happens, the price drops dramatically and you see a crash. And so this is, this is a concern, right? So if everybody has all their money in index funds and then they all pull at the same time, there's gonna be like a lot of pressure on like the trailing smaller stocks and that big long list of index funds to all have liquidity to sell at the same time that could cause a massive drop.

So that's a problem, that's a concern that might happen. My retort to that is, well again, there are market makers hedge funds who will be glad to step in and take advantage of that liquid or that inefficiency, right? If people are selling at super low prices and then they can buy and hold for a short period of time and collect the dividends or collect the future growth for this.

Now vastly underpriced talk, they're gonna step in, do it, step in and do it right. And you know, while you know Barry knowed that that day there's only 115 million of trading volume, like I think that's a little bit disingenuous because there wasn't a run on small stocks that day, that was just a normal day.

And you know, he's pointing out the difference in scale. But I think when the time comes, there are gonna be players like myself included, who'd be glad to start throwing cash to get dramatically underpriced stocks. And another retort to this is, yeah, it may crash, the market has crashed a lot in mystery.

You know, I talked about market crashes in a previous episode. I mean, if it does crash, so what, you know, we expect the market to crash and what we do is we just ride it out and then the market comes back.

You know, for example, if you offered to sell me a house today at 2007 prices, I would trip over myself to take that deal and basically every market in the world, pretty much, I mean I'm not an international stock expert, but certainly every market in the US because prices are way, way higher.

We did experience a huge drop after, you know, from 2007 to 2009, but then they climbed back up and you know, a few years later they were equal again and now they're way above. And so, you know, when you're talking about avoiding crashes, it's a very short term mentality, but I think wise investing is long-term mentality. And if you are constantly, you know, Michael Brewery makes his business on, you know, being an active manager, trying to take advantage of these short-term trends.

But for normal investors, we take advantage of the long-term trends, which is to buy and hold over long periods of time and just ride out the crashes. Because if we're guessing and jumping in on the market, jumping in and outta the market, it's way more likely to hurt us than help us.

Okay, problem number three, it makes companies less competitive through common ownership. This one's kind of an interesting one. It may be not obvious to first time index fund buyers or to casual investors, but basically when you buy an index fund, you're buying all of the companies.

So you're not just buying Delta, you're buying Delta and American Airlines and United Airlines and Southwest who's also publicly trade. I think they're all publicly trade. And this, as an owner of all the companies, our incentive as index fund owners is for them to collectively increase profits and reduce expenses.

Which when you look at it under a microscope at a single company, that might mean, Hey, let's you know, let's not compete, let's not advertise against our competitors. Let's just lower our expenses by, you know, cutting out our advertising budget, for example, and increasing profits back to the owner. That lack of competitiveness from individual companies could, you know, be bad for America.

That could lead to less innovation that, you know, if you know, one airline thinks they could get an edge by offering a certain type of feature or service or product, but they don't really care because that just is gonna take money out of their competitor's pockets and their owners don't care which airline it comes from. You know, that would be bad, that'd be bad for the consumer, it'd be bad for America.

And you know, would essentially turn, you know, every industry into a big oligopoly where they, you know, they know that they're all owned by the same index funds, so who cares? Just as long as people are still flying, they're happy.

My response to that is the people who run those companies do care. You know, the founders, the CEOs, the employees, everyone who you know works for that company, they are massively incentivized to improve their own situation, right? You know, if I am the CEO of Delta or the employee of Delta or a shareholder in Delta, you know, basically everyone who works for Delta, probably on the aggregate is much more heavily invested than Delta than they are. And in the other airline, you know, they wanna improve their own performance, their own investments and their own business.

And they have every reason to compete. And I don't think that because there's some percentage of their shareholders, which are kind of these like silent index fund owners, that they're gonna stop trying to make their own situation better. That's kind of the whole point of capitalism and the American dream, which is people look out for their own self-interest first.

And this whole problem of less competitiveness through common ownership seems a little bit silly to me when individuals are still running these companies.

Problem number four is index funds can have too much power. So as it stands right now, the big three index fund providers, Vanguard, fidelity, and State Street own about 17% of most major corporations. And you know, generally a lot of retail investors aren't voting in these shareholder meetings.

You know, publicly traded companies have shareholder meetings and boards and you have different voting rights based on the types of stock you own, stuff like that. And so basically, if you're a big shareholder in a company, your voice might matter in terms of things like CEO pay or who's on the board or direction of the company goes in. And when you look at these big three who collectively own 17% of most major companies, when you exclude non-voting shares, people who just don't show up to vote, they actually have about 25% of the voting power in the S&P 500.

That is striking some people as a concern. Basically just three people. The CEOs of those three companies, Vanguard, fidelity, and Schwab might have UE control over not just the future of a company, but the future of every company. And sure, I see how that could be bad. I don't know exactly how that would present itself. If you know the Vanguard, Fidelity, and State Street CEOs get together and I don't know, decide to really increase CEO pay or who know, I don't know what they would do that would be so nefarious, but I can see why that might be concerning if too few people have too much power.

My response to that is basically there's no evidence at all that they're doing this or that they ever would have any reason to do this. Index funds do have voting power. My understanding is that they have generally a very simple principle, which is just, you know, they don't really make a lot of waves because they don't hardly have an agenda.

They just vote with the board recommendation. Usually if they're ever, there ever was a point in the future where index funds started becoming highly dangerous to the market or to America, I think that would definitely be a point of consideration for legislators. And they would probably have some sort of like free market antitrust legislation that would be put in place.

And it could be something as simple as index funds can't vote, or, you know, would have to be a proxy and let their, you know, individual shareholders vote or something like that. But for me right now, I just this seems kinda like a, a scare tactic that, you know, index funds, he's like, you know, Vanguard's gonna suddenly become really opinionated in these company shareholder meetings. I don't see it happening.

But that leads us directly into problem number five with index funds, which is index funds are too passive. It's kind of the exact opposite of the previous problem, which is index funds aren't taking a ownership or a voting stance in these meetings. Some can make the argument that because index funds are so passive and are committed to being as lean and hands off as possible, they're trying to lower their expenses as much as possible.

They're basically asleep at the wheel, if you will, and aren't taking an active participation in these shareholder meetings and not voting or not voting intelligently. And I could say that being a problem, you know, like if certain companies decide to go rogue and normally, you know, very invested shareholders would be there to vote for the company's best interest, but a company decides to, you know, run their company to the ground or something because index funds aren't taking a part in voting.

I don't know, I'm trying to make an argument for this, but my retort to this is like, hey, you just said they have too much power now you're saying they have too little power. I mean it seems like staying out of those types of shareholder meetings is a good solution and I, I still believe there is and will be for the indefinite future.

Enough actively invested active managers, hedge funds, CEOs, board members, there's plenty of people who have plenty of voice to keep these companies on track. That index funds just generally being passive and collecting the revenues from those companies is a good solution.

So there you go. Those are like the five, at least as simply and as clearly as I could break them down, the five potential problems of index funds in my opinion, I think they're very, you know, forward-looking problems. I don't think any of them exist today. And I do think this anti-competitive or too much power or too big to fail situation where too much power is concentrated among just a very few index fund management companies is something to keep an eye on.

I imagine, you know, that might be a point of legislation at some point in the future, but as of today, I'm still not change anything. I still like having a direct line from the company or Globes profits directly into my wallet with minimum expense, which is what index funds provide. So I'm sticking with them.

Okay, that was the topic of today. We're gonna go to our question of the day from Francisco, from Houston.

Francisco: Hey Jeremy, I wanted to ask a question that might sound personal, but I think a lot of people might be in a similar situation, might currently have about $20,000 in student loans, about at a interest rate of about 4%.

What should my priority be as far as investing versus paying down debt? Should I go full force and paying this debt down as fast as I can or should I invest and make the minimum payment or maybe a little bit of both. I'm curious what you'd recommend.

Jeremy Schneider: Thanks Francisco. So he's basically asking how does he prioritize paying off his debt? Does he prioritize it first? Should he be invested along the way, a mix of the two? I mean this is a topic in which reasonable minds can disagree.

I think basically anyone who's looking out for the best interest of the investor would say with extremely high debt, you know, we're talking about credit cards that are 15, 20% by far, that needs to be your first priority other than, you know, just your basic, basic necessities of making sure you have a roof over your head, things like that.

But in terms of investing, any sort of high-interest debt has to be your first priority because you're never gonna get a reliable 20% return in sort of like a non-gambling situation. So for high-interest debt, absolutely prioritize it, but Francisco's saying, okay, 4%.

And I think a lot of people who have that kind of debt are thinking, well, if the market returns 10%, why would I ever pay my 4% interest debt? I could just pay that off as slowly as possible and invest and then be better off.

At the end of the day, that math is mostly true if you do put it into a spreadsheet and you do a 4% debt and you do a 10% rate return and you, and you drag down those columns and see what happens. For sure the 10% will go up faster than the 4% goes down. But there's a few things that spreadsheet doesn't take into account.

First is risk. The market doesn't always go up, right? And it's like, let's say Francisco with his $20,000 of debt puts $20,000. He'll say he had the cash in the extreme example and he put $20,000 to the market, then we had a big crash, his 20,000 could go to 10,000, his $20,000 investment could go to 10,000.

But then meanwhile his $20,000 of debt goes to 21,000 because it's, it's accruing interest and so he's much worse off and then he puts himself into an even worse situation. So that's like a volatility and risk that you don't see if you're just, you know, projecting numbers into a spreadsheet.

And the other one that I think is actually even the bigger reason is the mentality, behavior or psychology of money. You know, money is rarely just about investing, it's just about following the math of a spreadsheet. You know, it's usually very emotional whether that's how you spend, how you invest. And I think if you have a debt mentality, if you are used to having debt used to making those monthly payments used to borrowing money to, you know, to live, whether it's for student loans or cars or whatever, I think that's gonna leave you much worse off.

And so my recommendation to you, Francisco, is to keep things simple and just go ham on that debt. You go absolutely ham, that's HAM all capital. And if you wanna know what going ham is, it's just when you just go totally ham on something.

So remember that guy who ran a marathon in under two hours? That guy was going ham the entire time, he just went straight up ham for two hours, or James on jeopardy who was betting like he would just bet it all on every single daily double James on Jeopardy was going ham, these guys just went ham.

And so Francisco, I say, you go ham on the debt and other than a 401K match, if your company's just gonna give you free money for a 401k, I say the second priority after getting your 401K match relative to investing is to go ham and your debt good of all that debt.

If you can get that student loan payment out of your life, even at 4%, you're probably looking at several hundred dollars a month you've been making. If you can get the out of your life and then start investing that opens up your whole income to build wealth even faster.

And then you kind of get into this cash mentality where you're not just making payments and you're, you're just balancing all these payments you're making rather that you just have money and you're growing your money. And I think that behavior, that mentality, that psychology is much more likely to make you more wealthy going forward.

So that's all I have for you today. For the links and resources mentioned, please head to youstaywealthy.com/113.

As usual, I'll leave you with my two rules of building wealth. Rule number one, live below your means and that means not having debt. And rule number two, invest early and often. See you next week.

Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.