The economy continues to surprise on the upside.  The government revised its estimate of 3Q GDP growth from 3.8% to 4.3% (annual rate).  This was well above advance estimates and is a signal that the devastating effects of the hurricanes, and the surge in energy prices, are not having nearly the negative effects on the overall USeconomy that most economists and analysts (myself included) had predicted.  Productivity hit the highest level in two years in the 3Q, and unemployment continues to fall, despite the big plunge in consumer confidence in August and September.

The Bank Credit Analyst continues to predict that there will be a mild slowdown in the economy in the 4Q and also in the 1Q of 2006 due to the hurricanes, but that remains to be seen.  Beyond the 1Q of next year, BCA predicts the economy will remain strong in 2006.

The broad stock market averages are trying to break out of the two-year trading range as this is written.  The trend appears to be up, and January is typically good for equities.  Yields on Treasuries  have been rising since early September, but there is a good chance that rates will remain in a broad trading range for the next several months or longer.  Gold has broken out above $500 per ounce, largely due to concerns about rising inflation, but in BCA’s view, inflationary expectations are significantly overstated.  I would not chase gold at these levels.

This month, we take an indepth look at “index investing” which is the latest hot investment fad.  I’ll give you the pros and cons of investing in index funds.  While these funds are simple to understand and have low fees, they do go down whenever the markets go down.  As investors learned in the bear market of 2000-2002, index funds can result in huge losses.  This is why I generally don’t recommend them.

As we rush into the holidays, let me wish you a Merry Christmas, Happy Hanukkah and a very Happy New Year from all of us at ProFutures!  See the Halbert family Christmas photo on page 8.

Introduction

“Index investing”is growing like wildfire among investors today.  Mutual fund statistics show that a growing percentage of money flowing into the market is through the many investment products that track a specific market index.  And it’s no wonder why.  The allure of a simple, low-cost investment strategy tied to market indices that have been shown to grow over long periods of time sounds irresistible.

The main problem is that Wall Street’s advertising machine is only telling half of the story.  They often use historical time periods that are far longer than what most people have to invest, and they also fail to disclose how much an investor might lose in a bear market or major correction. 

I have always been wary of investments that include the potential to “fall off a cliff,” meaning that they have the potential to decrease in value rapidly.  Index investing is just such a strategy, and the losses can be substantial.  During the recent bear market of 2000 - 2002, the S&P 500 Index lost over 45% of its value, and the Nasdaq Composite fared even worse, losing over 75%!

Even with these huge market losses fresh on their minds, investors are still flocking to index investing as if there will never be another bear market or serious downward correction in the stock markets.  This is both foolish and dangerous, because we all know there will be more bear markets and major corrections in the future.

Part of the reason investors are flocking to index funds is there are so many different investment opinions and theories that investors just don’t know which way to turn.  Many choose to stay in cash rather than making the wrong decision.  They are simply paralyzed by all of the conflicting information out there.  I call it “information overload.”

While many investors are still sitting in cash, many more have flocked to index fund investing over the last year or so.  The investment industry is always willing to create and promote products to meet investor demands, such as hundreds of index funds, whether or not those products are really suitable for most investors.  This explains the explosion in index funds over the last several years, along with numerous other “ one-size-fits-all” investment products and strategies.

This may surprise you, but I am actually a fan of index investing, but only if applied correctly.  Some of the professional money managers I recommend use index funds as a part of their strategy.  However, index investing should never comprise one’s entire equity or bond portfolio.  Index investing is just another “buy-and-hold” strategy and just as risky.

In the pages that follow, I’m going to examine the recent index investing phenomenon, analyze the factors that have led to its popularity, and discuss some key disadvantages of this investment strategy that you may not hear elsewhere. 

Over the course of my career, I have found that most investors’ goals are very simple.  They want to put their money into investments that are: 1) reasonably safe; 2) have the potential to earn a reasonable rate of return; and 3) will not suffer large losses along the way.  While these goals are relatively simple, how you invest to achieve them is not a simple process.  I trust that everyone reading this newsletter understands that fact.

Index Investing Is Big Business

In case you haven’t noticed, index investing is booming right now.  It seems that each week we see a new index fund or “exchange-traded fund ” (ETF) announced.  All of these funds seek to provide performance that approximates the performance of a specific market index.  Index funds are also known as “passively managed” funds since there is no manager selecting individual stocks based on their merits, or doing any discretionary trading.  All market positions and the percentages they represent in the fund are dictated by the holdings of the underlying index.  Basically, the funds are on auto-pilot.

One of the early pioneers of index investing was John Bogle, founder and former CEO of the huge Vanguard family of mutual funds.  Vanguard produced the very first index fund in 1975, and it still exists today.  The Vanguard 500 Index Fund is not only the largest index fund, but it is also the largest mutual fund in the world with over $70 billion in assets as this is written.  Due to Bogle’s belief in index funds, Vanguard has dozens of such funds, and  has grown to a dominant position in the mutual fund industry.  This, in turn, has led to hundreds of other index funds at other mutual fund families that compete with Vanguard.

In the mid 1990s, Rydex Funds took indexing to the next level by offering a number of different mutual funds based on a wide variety of market indices.  Not only did these funds provide for a wider array of indices, but they also allowed up to 2-to-1 leverage on some funds, and even the ability to “short” the market using inverse index funds.  Perhaps most importantly, Rydex allows investors to switch among its various index funds - at will - without any early redemption fees.

Rydex was soon followed by ProFunds and Potomac Funds in the generation of index funds and ETFs.  As a result, the proliferation of index funds and ETFs continues.  There are now funds and ETFs that mimic virtually every market index as well as those for specific market sectors, international market indices, and even gold and precious metals indices.

The Basics of Index Investing

The entire idea driving index investing is the premise that an investor using actively managed funds cannot do better than the market indices over long periods of time.  Actively managed funds are traditional mutual funds where the fund manager uses analytical techniques in an effort to identify stocks that will outperform the overall market.

Proponents of index investing point to various studies through the years that have shown that active management does not provide any long-term benefit over and above investing in market indices.  One of the first of these studies was presented by Burton Malkiel in his 1973 book, “A Random Walk Down Wall Street.”  It is thought that this book was at least partially responsible for John Bogle’s decision to create the Vanguard 500 Index Fund back in 1975.

Malkiel’s work was soon followed by similar articles from Charles D. Ellis in 1975, and William D. Gray III in 1983.  Perhaps the best reasoning behind index investing can be expressed using Malkiel’s own words in a 1995 “Journal of Finance” article:

“Most investors would be considerably better off by purchasing a low expense index fund than by trying to select an active fund manager who appears to possess a ‘hot hand’.”

Thus, the main tenet of index fund investing is that active mutual fund managers cannot do any better than the major market indices, so why try?  They contend that you are better off just putting your money in one or more index funds and let the market’s long-term uptrend take care of you.  But as I will point out below, it’s not always so simple or easy  (ie - think bear markets).

Based strictly on available statistical analyses, these prophets of index investing seem to have a point.  For example, they cite the statistics that no actively managed mutual fund has ever outperformed “the market” over a 40-year period, and over 90% of all actively managed funds fail to outperform “the market” over even a 10-year period.  I’ll discuss these findings in more detail below, but suffice it to say that such statistics make for powerful marketing materials for the index crowd.

Index investing believers also have another powerful argument, and that is in the area of fees.  Because index funds and ETFs are passively managed based on whatever the underlying market index holds, the fees on these funds are far lower than actively managed funds.  In addition, as the index fund gets larger, there is little additional work or expertise required to manage the fund, so the fund expenses tend to get lower as a percentage of fund assets as the fund grows in size.  For example, the Vanguard 500 Index Fund currently has a total expense ratio of only 0.18%, as compared to about 1.5% for the average actively managed fund.

Most of all, however, I think the allure of index investing lies in the widespread advertising campaigns by the fund families, and the fact that indexing is simple to understand and implement for the average investor.

Chinks In The Index Investing Armor

Before I discuss some of the arguments against index investing, let me say that I am a big fan of both index funds and ETFs.  I feel that the ability to “buy the index” has changed the investing landscape in a number of positive ways, though I don’t agree with proponents who recommend buying and holding only index funds.  As noted earlier, several of the professional Advisors whose programs I recommend use these index funds to facilitate their active management strategies, so I am a big fan.

That being said, I do not think a buy-and-hold investment strategy using only index funds is the best alternative for most investors.  The main reason I do not recommend such a strategy is the passively managed nature of the index fund.  Index funds, by their very nature, will not exit positions and move to cash during bear markets or downward corrections.  An index fund will follow its underlying index, even if it dives right into the dirt!

Index fund proponents say that this is no problem - just diversify among a variety of index funds covering various stock and bond asset classes, and everything will be OK in the long run.  This strategy is illustrated by an investment offer I recently received from a financial Advisor.

The Problem With Carefully Selected Time Periods

The Advisor noted above recommended only “index” funds allocated among a variety of selected funds, based on traditional asset allocation principles.  The Advisor went on to illustrate the performance of a set of index funds over a 25-year period of time from 1979 through 2004.  The performance was excellent, of course, especially as compared to fixed rate investments like CDs, money market accounts and fixed annuities.

The Advisor’s implication was clear: the market indices will do well over long periods of time, so all you need to do is invest in his special blend of index funds and you’ll be just fine.

Sorry, but I'm still not convinced.  Here are just a few of the fallacies of this argument, in my opinion:

1.  It assumes the next 25 years will be the same as the last 25 years. Let’s see, did a gazillion Baby Boomers retire in the last 25 years?  Were we afraid of terrorist attacks on our major financial centers prior to 2001?  Will Medicare and Social Security costs be the same percentage of government spending in the next 25 years as they were in the last 25 years?  (Hint: “NO” is the appropriate answer to all of these questions.)

2.  The 25-year time period cited as an example doesn’t necessarily correspond to any individual investor’s actual time frame.  What if an investor’s time frame had them needing their money for retirement in December of 2002 during the bear market?  Index investing was not very popular during the bear market of 2000-2002, especially near the end.

3.  It doesn’t hurt your argument when you choose a 25-year period that just happens to include the longest bull market in history, along with the  technology-led stock market bubble in the go-go 90s.  But let’s roll the clock on back a bit.  What if we chose a period of time from 1966 through 1982.  Over this 16-year span of time, the stock market went nowhere. 

You may not recall, but back in the 1970s and early 1980s, banks and fixed annuity salesmen were using the lousy stock market performance to persuade investors NOT to invest in the stock market.  In investment analysis, timing is everything.  The ability to reach your investment goals depends upon how the markets act in the next 5, 10, or 20 years, or whatever your particular investment time period may happen to be.  Furthermore, there is absolutely no way to insure that the performance of any historical period of time will be duplicated in the future.

Even John Bogle, the father of index investing, has pointed out that “each and every comparison we see is period-dependent.”  This means that the time period you choose can greatly affect the outcome of your analysis.  I have written about this before, but it is especially important in regard to index investing.

A recent article by Christopher Carosa, CTFA in the “Journal of Financial Planning” magazine illustrates this shortcoming.  Carosa analyzed the equal-weighted average annual return of all US equity mutual funds over a 25-year period from January 1975 through December 1999.  Over this period of time, the average mutual fund return was 16.99%, which was less than the 17.26% average annual return of the S&P 500 Index.

However, if you expand the data through June of 2004, the mutual fund return was 13.93% versus the S&P 500 return of 13.73%.  Thus, the period of time selected for the analysis can significantly affect the outcome.

Carosa’s research went on to discuss two very important flaws that have framed the active versus passive investment debate over the years.  His article is long and very technically oriented, but its conclusions were that these two flaws knock a big hole in the argument that passive management (i.e. - index investing in this case) consistently beats active management.  Carosa’s study concluded:

“An analysis of investment return data from January 1975 through June 2004 shows active investors in U.S. equity funds performed better than the S&P 500 two-thirds of the time and by an average of 2 percent annually.” [Emphasis added, GH.]

In addition, Carosa’s research showed that investors in actively managed mutual funds actually took on less risk than the index.  A complete copy of Carosa’s research can be found in the October issue of the “Journal of Financial Planning” magazine.

4.  The discussion of various time periods brings up an interesting point.  Historical analysis does show that stocks increase in value over long periods of time.  Yet, there are many shorter periods in which stocks do poorly, or even lose money. 

You often see performance data for the stock market illustrated over 25 years, 50 years and even 75 years.  Yet few people trying to make investment decisions today have a 75-year time horizon!  Likewise, few people have even a 50-year time period to invest.

Nevertheless, there are a multitude of investment articles in the financial press using these long-term time frames to illustrate the benefits of index investing.  Even the shorter 25-year time frame may not be feasible for many of today’s investors, especially Baby Boomers who have started saving and investing late in their careers.

Statistics tell us that we get our kids out of college and hit our high-earning years in our late 40s and 50s.  That’s when we are supposed to be able to sock away lots of cash for retirement.  Yet as noted above, many of today’s Baby Boomers have been busy living the American dream, and not putting away much in the way of a nest egg.  They figure that these high-earning years will carry them through to retirement.

But look at the timelines.  A worker age 45 has 20 years until retirement at 65 (assuming that this artificial determination of human obsolescence continues to be the norm).  A 50-year-old has only 15 years, and at 55, you’re looking at only 10 years to accumulate wealth for retirement.  Are there lots of 10-year periods during which the major market indexes did poorly?  You bet there are!

So, you have to ask yourself, what historical 10-year period will the next 10 years be like?  Up, down, sideways?  Don’t know?  Neither do I, and neither do economists, financial planners, mutual fund managers, or anyone else.

If you choose an index-only strategy, and the next 10 years just happens to be a down period, you not only fail to reach your retirement goals, you can actually lose money in index funds.  This is the main reason I do not recommend index investing as your only strategy.

Do Low Fees = Good Investments?

One area where the index investing proponents have been successful in wooing investors is that of fund fees and expenses.  As noted earlier, index fund fees are typically considerably lower than actively managed funds.  The Wall Street crowd and many fund families have convinced many investors to  automatically reject any investment or fund with expenses greater than those of an index fund.  Many investors have bought into the idea that active management doesn’t pay, so they are not willing to pay higher fees for the expertise of an active manager.  They use fees as a simple way to eliminate alternatives from their investment radar screen.

Unfortunately, this simple criterion can eliminate many qualified alternatives and many good actively managed mutual funds.  Think about it this way: do you drive the least expensive car?  Why not?  Don’t all cars offer you a mode of transportation?  Do you shop for the least expensive doctor, dentist or lawyer?  Those who do many times find out exactly why they charge fees under the going rates. 

The important thing is not always what fees are being charged, but how the investment program has performed net of all fees and expenses. 

Many people will pay more for a product or service if they can see, hear or feel “added value,” and investments should be no different.  The problem with money management is the ability to quantify an Advisor’s (or fund manager’s) added value since it is in the form of future potential results, which no one can predict.  Thus, all we have to go on are the statistics of past performance, but even these can be manipulated by selecting the best time period, as Mr. Carosa’s research has shown us.

I mentioned above that a statistical analysis of mutual funds shows that over 90% of equity mutual funds do not beat the market indices over the last 10 years, which is true.  However, you have to stop and ask why that may be true.  Over the last 10 years, we have experienced some of the best stock market performances on record.  In such hot environments, few  Advisors or fund managers are likely to do better than the market.

I also noted above that no mutual fund beat the overall market over a 40-year period.  This is just another example of where statistics can be accurate, but misleading.  When considering this statistic, it is important to remember that superior performance  is usually “ manager-specific.”  As you probably know, there are few mutual funds that have had the same manager for the last 40 years; managers tend to change fairly frequently.  Thus, it’s not surprising that no mutual fund beats the market over a 40-year period, since most mutual fund managers do not have a 40-year career at a single fund. 

Finally, I find it very interesting that there are some financial services companies that extol the virtues of index funds and low fees to their so-called “retail” investors, while at the same time they are pushing hedge funds to their wealthy clients.  As you probably already know, hedge funds carry some of the highest fees of any investment vehicle.  Most hedge funds will charge a set management fee of 1% to 2%, plus an incentive fee, which can be as high as 20% of new profits.  Plus, hedge funds have their own set of additional “risk factors” on top of the market risk that applies to all equity investments.

So, if high fees are such a bad thing, why are these same firms recommending that their wealthy clients rush into hedge funds as never before?  The answer is that there are some money managers who are able to provide value over and above their fees in the form of consistent absolute returns.  In addition, these managers can also reduce the risks associated with being in the market, which help to lessen the probability that a major market downturn will eliminate a large chunk of equity right when the investor needs it most.

Campbell &Company is a good example.  Campbell is the futures Trading Advisor with which I have the largest allocation of money in several of our futures funds.  Campbell charges fees that are substantially higher than index mutual funds.  Yet Campbell’s performance over the years, net of all fees and expenses, has been very impressive.  (Past performance is not necessarily indicative of future results.)

Of course, there is no guarantee that high fees lead to successful investment results, but it is true that a successful money manager will charge more than your typical index fund, since a great deal of time and talent is required to guide a successful fund strategy.  When I hear that over 90% of all fund managers don't beat the market, I don’t think that I should give up and settle for an index fund.  Rather, I want to know who makes up that 10% that is doing better than the markets.  With over 5,000 stock and hybrid mutual funds out there, that means there are a lot of good mutual funds that bear searching out.

What About Risk Management?

As I noted above, most investors seek investments that are: 1) reasonably safe; 2) have the potential to earn a reasonable rate of growth; and 3) will not suffer large losses along the way.   My biggest problem with index investing is that it can fail all three of these tests.  Here’s why

First, on the issue of safety, you could say that index investing passes this test in one sense because there is little likelihood of losing money through embezzlement or fraud.  However, safety means a lot  more than protection from fraud. 

As I mentioned above, there are some new index funds that allow investors to ramp up the leverage (i.e. - risk).  Some newer funds offer 2-to-1 leverage, and as a result, the volatility can be very severe at times.  Also as noted above, there are several index mutual funds which “short” the market, meaning that they will lose if the markets go higher.  I don’t consider that these funds pass the safety test.

Obviously, the ability to short the market and leverage positions offers a lot of flexibility, but it also offers a lot of additional risk.  Unless managed by a competent professional using a disciplined strategy, I consider participation in leveraged and short funds little more than gambling.  You might win big, but you can lose just as big, and may never be able to recover your losses.

As for the second test of the potential to earn a reasonable rate of growth, index investing proponents would say that index funds pass this test with flying colors, considering the historical long-term return of the stock market. 

However, as I have shown in this article, stock market returns are very time period-dependent.  The shorter your investment time horizon, the higher the chance is that you will hit a bad period, and the higher the chance is that index funds will provide results below their long-term average. 

And let’s not forget that there have been examples in the past where the stock market has gone virtually nowhere for 10, 15 or even 20 years.  In these  market periods, you need successful professionals and active management strategies more than ever.

On the final qualification that the investment programs avoid large losses along the way, index investing fails miserably.  Since there is no active management of the underlying portfolio, the investor is destined to rise and fall with the markets.  During the past bear market of 2000 - 2002, the major market indices had some tremendous drawdowns in value, with the S&P 500 losing over 45% of its value.  An index fund tied to the S&P500 is destined to suffer a similar (or larger) loss. In 2000-2002, the Nasdaq Composite Index lost over 75%, and some index funds did likewise.

The bottom line is, if you are soley invested in index funds, and the markets go down, your investment is certain to lose money also.  As pointed out above, index funds do not get out of the market and go to cash when the markets go down as they did in the bear market of 2000-2002.

My staff and I have personally talked to a number of investors who needed their money for retirement during this time, only to find that a large part of their investments’ values had vanished due to the bear market.  Even if I were sold on the value of index investing over the long haul, I would still not recommend it to my clients simply because of this last shortcoming.

Conclusions

I would like to say that the recent article by Christopher Carosa and this newsletter would slow down the stampede into index investing.  Sadly, it’s not going to happen.  There are far too many large investment firms that have invested too much money in the development and promotion of index investing for them to ever admit that there may be shortcomings to this strategy.

In addition, investors who yearn for simplicity will continue to flock to the index investing programs because of their ease of understanding and participation.  Unfortunately, what these investors do not realize is that there is no single “best” investment strategy or alternative for all investors, or even for an investor’s entire portfolio.  While the one-size-fits-all index programs appear to be very attractive, they have shortcomings that can lead to disappointment and potentially large losses if you happen to need your money at the wrong time.

As always, I much prefer investment programs that: 1) are actively managed by proven professionals; 2) will exit the market or “hedge” should large downturns occur; and 3) focus as much attention on avoiding large losses as they do on making money.
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Merry Christmas, Happy Hanukkah
& A Very Happy New Year To All!

Let me take this opportunity to wish you a great holiday season and a Happy New Year.  To those of you who are clients, let me sincerely thank you for your business.  We have such a great group of clients!  I am very blessed in this regard, and very thankful for your continued confidence.  For those of you who are not clients, I hope you elect to join our group soon. 

Happy Holidays From The Halberts