The popularity of index funds has absolutely exploded over the last 20 years, with investors collectively transferring a couple hundred billion dollars every year from actively managed to passively managed funds.
And the reason for this has been clear: index funds vastly outperform actively managed funds.
Although a minority have stood out as successful, most active funds including mutual funds and hedge funds are plagued by high fees, high turnover and taxes, and mediocre investing results net of fees to show for it.
According to the latest S&P Dow Jones IndicesSPIVA research report, 92-95% of actively managed funds failed to beat their passive index benchmarks over a 15-year period.
Worse yet, there’s no reliable way to identify the small number of funds that will go on to outperform in the future; we can only look backwards and identify the ones that did.
The low cost, low turnover, automatic nature of index funds has been a superior investment compared to active management for decades, and this trend has been catching on more and more. Now, indexed ETFs have further expanded the popularity and flexibility of index investing.
Vanguard, the world’s largest index fund company, now has over $5 trillion in assets, and Blackrock, the second largest provider of index funds and ETFs, has another $4 trillion in passively managed assets.
But there’s a huge difference between past performance and future performance, and index funds might be setting up investors for a generation of disappointing returns.
Why returns will likely be lower going forward
The S&P 500, the most common benchmark for index funds to follow, has given investors more than 9% annualized returns since the 1920’s. But that rate of return has by no means been smooth.
If you invested in the late 90’s, for example, your investment would have been flat and choppy for the next decade and a half until you finally broke to a new high point. A balanced allocation between stocks and bonds would have improved this somewhat, but returns still would have been less than great.
And this is a predictable result rather than random. Dr. Robert Shiller, an economics professor and Nobel laureate at Yale, two decades ago introduced the Cyclically-Adjusted Price-to-Earnings (CAPE) ratio, also known as the Shiller P/E ratio. It divides the current market price of the S&P 500 index by the inflation-adjusted earnings of those companies over the last ten years, and the result is a quite accurate representation of how overvalued or undervalued the market is compared to historical norms.
The higher the Shiller P/E is, the more investors are currently paying per dollar of earnings.
Here’s a chart of the Shiller P/E that I constructed using Shiller’s data:
The well-known fact is that the Shiller P/E at any given point is inversely correlated with investment returns over the next 10 and 20 year periods.
In other words, if the Shiller P/E is high, then your investment returns are likely to be choppy and sideways over the next decade or two, as these high valuations come back down to earth. High valuations result in lower dividend yields, lower growth from reinvested dividends, and lower EPS growth from corporate share repurchases, and less room for valuation increases during your holding period, resulting in mediocre or poor returns.
Robert Shiller has quantitatively tracked the forward 20-year returns of the S&P 500 compared to the Shiller P/E at any given point retroactively since the late 1800’s. The conclusion is that whenever the Shiller P/E was over 25, the rate of return over the next 20 years was negative.Here’s his data, from Irrational Exuberance:
More recent analyses using shorter ten-year periods has shown similar results; when the Shiller P/E of the market isover 25, the rate of returnover the next ten years varies between about 8% at best or -4% at worst, which is a really crappy range.
At the risk of putting too much emphasis on just one valuation metric, another way to measure stock market valuation is a method popularized by Warren Buffett.
To do this, you simply divide the market capitalization of all stocks (the total price of all shares of all public companies) by the gross domestic product (the price of all goods and services produced in that year). If the ratio is higher than normal, it means share prices have outpaced actual production.
This ratio almost perfectly correlates with the Shiller P/E:
As the Shiller P/E of the S&P 500 currently stands at over 30, and the Capitalization/GDP ratio stands at over 120%, a century of data tells us that returns over the next 10-20 years are likely to be mediocre.
Stock market prices have vastly outpaced corporate earnings and national output, resulting in a highly-valued market, low dividend yields, and low buyback returns. The only historical periods where we had higher valuations than today were in the late 1920’s and the late 1999’s; both of which ended horribly for stocks.
John Bogle, inventor of the index fund and founder of Vanguard,outlined a simple rule of thumb:
Forward returns = dividend yield + earnings growth +/-changes in valuation
In other words, if the S&P 500 yields 2% right now, and earnings grow at 6% per year, and the high P/E deflates at a rate of 3% per year over the next decade, then your rate of return by investing in the S&P 500 over that period would be about 5%. This is directly in line with the high end of what 150 years of Shiller’s data suggests will most likely occur.
If you want additional proof, forget these broad valuation metrics and apply discounted cash flow analysis to a bunch of major companies you’re interested in buying. That’s the gold standard of valuation measurement on an individual-company basis.
You’ll see that for many companies out there, the fair value calculation you come up with is below the current market price unless you either a) assuming ridiculously high growth or b) use a very low discount rate, which means a low rate of return.
- Read More: Valuation Methods Overview
Examples of how bad it can get
The S&P 500 has experienced relatively long stretches of flat returns. After the 1929 peak, the market took 27 years to reach new highs in inflation-adjusted terms. After the 1968 peak, it took 24 years to reach new highs in inflation-adjusted terms. And after the 2000 peak, it took 14 years to reach new highs in inflation-adjusted terms.
Europe reached a peak in 2000 and still hasn’t recovered even in nominal terms, two decades later:
Japan has shown an even worse outcome. The Nikkei 225, the index of Japan’s largest companies, reached its peak in 1989 and three decades later still isn’t at new nominal highs:
Basically, it’s a mistake to assume that the 9% annualized S&P 500 performance during America’s golden years, beginning after World War II as the world’s sole superpower and extending into the 21st century, during an unprecedented time of growth and innovation, will be repeated forever.
The United States now faces slower GDP growth, a higher public debt burden, an aging population, healthcare and education costs that are more expensive than anywhere else in the world, flat inflation-adjusted median household earnings over the past two decades, and a multi-trillion-dollar unfunded public pension bubble.
Even without thoseproblems, the high market valuation alone indicates that forward returns are likely to be poor. Adding those things on top of it paints an even more stressful picture.
I’m not saying we won’t get growth over the next decade or so, but it’s likely that returns won’t be great.
Even if P/E multiples remain higher than normal for the long-term, it will keep dividend yields low, reinvested dividends less powerful, and share repurchases less effective, resulting in at best mid-single-digit returns. In almost any reasonable case, forward returns are likely tobe lower than 9% per year.
Bonds won’t save us this time
A counterargument that some will make to this article is that a diversified portfolio that is continually re-balanced between stocks and bonds will take care of this, and improve our overall returns. And I do recommend holding bonds in a diversified portfolio.
Historically this approach has been helpful, with bonds providing stable returns over 6% during most yearsfor decades, but the data also indicate that bonds will likely produce worse results going forward as well.
This is a chart by the St. Louis Federal Reserve of the federal funds rate over the last several decades:
Here’s the problem. Bond prices and interest moves are inversely correlated. As interest rates drop, it pushes up the value of existing bonds. This four-decade long-term reduction in interest rates from a very high level has propped up bond returns for the past 40 years. And for the last decade, we’ve had an stretch of zero or near-zero rates.
You don’t even need to accurately predict how much and how quickly interest rates will rise to determine that bond returns are likely going to be poor. If interest rates do go up, then current bonds will reduce in value in the short term, but future bonds might produce a decent real rate of return. On the other hand, if we have a long era of fairly low interest rates, then it won’t badly impact current bonds, but all present and future bonds would have a low rate of return.
Ten year treasuries right now, for example, give you negative real returns over their holding period. The interest rate that investors receive from holding them is slightly lower than the current and expected forward official inflation rate. If interest rates remain low for long, bond returns will continue to be poor, probably failing to keep up with rising expenses. They lose money slowly at these levels, in other words.
Either way, without bond returns being propped up by a four-decade super cycle of interest rates descending from unprecedented highs to unprecedented lows, bond returns are likely to be disappointing. Low interest rates are bad for bonds in the long term. Rising interest rates are bad for bonds in the short term. High inflation, if we get it, is bad for bonds in all terms.
Foreign stocks might help
The standard index retirement portfolio, based on Modern Portfolio Theory, looks something like this:
A large part is usually allocated to American stocks (either just the S&P 500, or both large and small cap companies and maybe REITs), and then smaller chunks are allocated to bonds and foreign stocks. The bond component is usually allocated a larger and larger share as the investor ages. That’s standard practice.
The foreign indices used by most indexers, including Vanguard and iShares, are distributed proportionally based on economic size. In other words, a broadly diversified foreign index fund is usually heavily weighted into slow-growth Japanese and European stocks, because those are the largest international economies, with smaller parts allocated to other countries like Australia, Canada, and possibly some emerging markets.
Read more here about why that’s a problem and how to fix it.
In short, Japan faces population shrinkageand the highest public debt-to-GDP ratio of any country in the world, and is the single largest area of concentration for these international indices, accounting for between 1/5th and1/4th of their total holdings.
However, I do think a decent weighting in emerging markets may help boost returns over the next 10-20 years. They have better growth prospects and rather low valuations. That may be investor’s one saving grace.
Are Index Funds a Bubble?
Some famous investors have referred to index funds as a bubble.
Michael Burry, one of the famous investors that shorted the housing bubble, is the latest celebrity investor to call index funds a bubble. One of the most detailed counter-arguments to this claim has come from Ben Carlson of Ritholtz Wealth Management. Both articles are worth a read.
Let’s focus on some of the major issues that opponents argue regarding the index fund bubble hypothesis.
#1) Money Chases the Top
Most index funds are weighted by market capitalization, which means that the more valuable a company is, the higher an allocation it gets within an index fund.
When index funds were originally created, they represented a very tiny piece of total invested capital, and the bulk of the money was actively-managed. The active managers set market valuations, while index funds basically just skimmed off the top, copying the valuations that the markets assigned to various stocks.
However, because index funds are gaining in popularity and becoming a larger and larger percentage of total invested capital, they may be increasingly “setting” the valuations rather than just matching the valuations, like the tail wagging the dog rather than the other way around. In this case, excess money would theoretically flow into the largest mega-cap stocks, propping up their valuations to unreasonable levels.
I personally have not seen much evidence of this issue, at least to any degree that I’d call a bubble. For example, I’ve specifically examined the valuations of mega-cap stocks like Apple, Alphabet, Amazon, and Microsoft to determine if they are dramatically overvalued, and the answer is no.
There are plenty of other stocks like Netflix or Tesla that I consider far more overvalued, but Netflix is much smaller than those mega-caps and Tesla isn’t even in the S&P 500. So while there are plenty of overvalued stocks out there, the ones at the top of the S&P 500 are not necessarily the worst offenders.
That being said, I do like to look for stocks that are not included in major indices like the S&P 500, because there’s a greater chance of finding cheap high-quality companies.
#2) Liquidity Mismatch
Some ETFs have become so liquid (frequently traded), that they are orders of magnitude more liquid than some of their more thinly-traded underlying holdings.
This is one of those issues that likely isn’t a problem until, one day, it could be. In other words, during a bull market this is fine, but if there is a major market crash and a lot of people want to sell at once, it could cause major liquidity problems and huge gaps down in pricing for some less-liquid securities.
While this could be a good opportunity for value investors if it were to occur, it could hurt index investors. It’s unclear if this will ever cause an issue in practice, but it’s one of the reasons I prefer to hold individual stocks along with some of my ETFs.
There have been passive index funds and benchmark huggers (active managers that closely mirror the index) for decades, but only in the past decade have we seen a massive rise of ETFs, which put massive liquidity right into the hands of individual retail investors and trading algorithms.
#3) Socially Responsible Investing, Or Lack Thereof
Index funds are in many ways the opposite of socially responsible investing.
Corporations are increasingly being owned by passive asset managers, who are not just passive with their investment decisions, but are also passive with their corporate governance. They generally don’t scrutinize candidates for the boards of companies they own, and they usually abstain or vote no on shareholder proposals.
For more detail on this topic, read this article.
The short version is that I don’t think it’s necessarily a great idea for vast percentages of the population to purposely be totally oblivious to the companies they own, and take no part in the shareholder governance. It’s like being a citizen, never voting, and then complaining about politicians being lame.
Risk Mitigation
Given some of the issues with index funds, there are some things investors can do to protect themselves.
#1) Save and invest more money
This is the least sexy approach, but important nonetheless.
Investors should plan for 3-5% returns rather than 7-10% returns. Put more money away so that you require lower returns to meet your goals.
It’s simple, but hard, especially because middle-class inflation-adjusted wage growth has been flat while healthcare and education costs have skyrocketed. There’s little other choice right now, though. And if returns somehow are better than all the data suggest, then great! You’ll have more money.
#2) Make rational adjustments
Consider usinga light-handed active touch on your otherwise passive portfolio.
When market valuations approach historical extremes, there’s good evidence that adjusting the weighting accordingly can help your portfolio outperform. When equity valuations are high, it makes sense to reduce exposure. When equity valuations are low, it’s not a bad idea to increase exposure.
Backtesting over a century shows that a stock/bond portfolio that is automatically tweaked based on the Shiller P/E outperforms a static stock/bond allocated fund. In other words, when the Shiller P/E starts to get high, allocate a bit more heavily to bonds. When the Shiller P/E becomes low, allocate a bit more heavily to stocks.
- Read more: Risk vs Volatility: How to Profit from the Difference
#3) Focus on income generation
Another approach is to utilize covered calls and cash-secured put options more frequently, which can be used on individual stocks or indexed ETFs.
They’re underused strategies that do exceptionally well in exactly this kind of market environment, because they can generate 10% or more in income and returns even when the market is flat.
A portfolio that incorporates put-selling and covered callsdoes very well in flat, sideways, choppy markets, while also giving decentreturns in bull markets and reducing your downside risk in bear markets.
Gimmicky strategies that rely on just one tactic, like a pure covered call selling strategy, are not smart. Instead, using different tools for different market environments makes sense. And right now, selling optionsthat can give you a lot of income in a flat market, and that can give you decent downside protection,are one of the more powerful tools you can employ.
In addition, focusing on safe high dividend stocks can help you weather periods of low returns. An attractively-valued stock with a 4-6% dividend yield, growing it at 2-5% per year, can give pretty solid returns through a business cycle.
A lot of people invest in equities poorly. They buy excitedly at the top of a market cycle, sell in a panic at the bottom of a market cycle, and don’t understand various valuation metrics or other ways of analyzing stocks. For this reason, many advisors tell people to never touch individual stocks, that it’s like playing with a loaded gun and just bad for them, and to stick to index funds or actively-managed funds.
For investors that take the time to learn and understand how to select individual stocks for their needs and properly manage a portfolio of them, they can achieve a lot of the benefits of index funds (great long-term returns with low fees) without some of the downsides (potential overvaluation, liquidity mismatches, and poor corporate governance).
Like fixing your own home, it’s something that needs to be taken seriously but can give good benefits if you choose to do so. If you want to learn more, read some of my core articles, or check out my book on the topic.
#4) Expand Your Investment Horizon
Adding individual stocks, foreign equity indices, or alternative asset classes can help reduce the impacts of poor equity index returns on a portfolio.
Historically, poor decades for stock performance tend to be great decades for other asset classes. For example, the 1970’s were a bad time to be a stock investor, but a great time to own commodities.
With precious metals, digital assets, commodities, and some other alternatives, an investor can diversify their returns away from being reliant on whatever the S&P 500 does.
Final Words
While index funds have been an incredibly important investing strategy, there are appears to be over-enthusiasm for what they can do, both among institutional and personal investors. For some people, there’s also a devotional approach of never adjusting the investment strategy to keep up with new market conditions.
Investors don’t necessarily have to be bound by S&P 500 returns, and active portfolio management doesn’t necessarily have to mean “picking hot stocks” hoping for blockbuster returns.
Instead, it can mean a patient focus on long-term investing to outperform in the face of overvalued slow-growth equity markets and low bond yields, or can mean mild adjustments to take into account unusual market valuations.
Further reading:
- How to Seriously Build Wealth- in One Chart
- How to Invest Money Intelligently- The Guide to Get Started
- How to Increase Your Credit Score (to 800+)
