Indexing Will Fail? Really?

Deconstructing doom and gloom.

Marketwatch ran an article by Niels Jensen titled Why indexing will fail investors in the coming dismal decade for stocks. Jensen laid out a bleak set of factors that he feels will create a lot of problems for broad equity indexes and has some ideas on how to position in his scenario.

I have mentioned Jensen in previous blog posts. He had very similar comments back in 2010. He was averring for a very large weighting to absolute return (he runs an absolute return fund) which I pushed back against then and would do so now (more on that below). Since that April 2010 blog post the S&P 500 is up 133% per Yahoo Finance. That big of a run in just eight years doesn't come along very often and if you need stock market growth for your financial plan to work, that is the kind of move you can't afford to miss by having 30-40% in something that seeks 3-5% annualized (Jensen was suggesting 30-40% in absolute return back then). The only exception would be absolute return as a substitute for fixed income not equities but that isn't what Jensen had in mind. To be clear I wouldn't completely replace fixed income with absolute return but you're not forgoing growth with that allocation.

The factors Jensen cited now as follows;

  • A debt super cycle ending
  • Retiring baby boomers leading to decreased economic activity
  • Declining spending of the middle class
  • Threats from Asia
  • The end of fossil fuels
  • Mean reversion in the relationship between asset price growth and GDP growth

Of course any or all these things could be disruptive to equity market growth, no argument. But none of these things are new, they are well known (this just in, we have too much debt and a lot of people are retiring!). When the next bear market comes any or all of those threats could be part of the story but we have had bear markets before and they too came about from various threats coming to fruition.

Part of what Jensen sees is what I will call a bumpy ride to nowhere in terms of average market returns. Ok, we just had one of those in the previous decade for US equities. A simple allocation to foreign equities helped to make up for much of what was not gained here at home. Additionally, a defensive strategy that successfully avoided the full brunt of 2008's decline (I've literally written a couple of thousand posts on how I do this) would have added meaningfully to average annual returns for the decade. Returns being great or lousy for years at a time is not a new thing. Some sort of active asset allocation (whether that means passive funds or not) can be a work around, no guarantee though.A run of relatively weak returns is absolutely plausible. I would focus less on trying to predict when or if this will happen so much as have a strategy if it does happen.

Jensen suggests you invest in value stocks, get portfolio income from stock dividends not bond interest, invest in water and invest in illiquid assets. No mention of absolute return in the article, maybe that's in the book he's trying to sell. Oh, did I not mention he wrote a book about this? As far as his suggestions, value stocks have a tendency to outperform over the long term but they have been left far, far behind at times like the last year and half. No growth stocks in that time would have been painful, I wouldn't make such a big bet. There are plenty of fixed income strategies/funds that can get you yield without taking interest rate risk but having dividends come from the stock portion of your portfolio is never bad advice. I have owned an ETF that focuses on the water theme for clients for more than 12 years. It has frequently outperformed the S&P 500 but has lagged some in the last few years. I believe in the theme but would not go heavy in it or any theme, 2-3% in a theme is usually what I target.

It is crucial to take the doom and gloom articles with a grain of salt, especially if the author has been so spectacularly wrong before, 40% out of equity into absolute return in 2010 was dreadful advice. I am huge believer in absolute return but many of the funds/strategies don't deliver as hoped. Many clients have 6-7% in absolute return-ish funds currently which is a lot let alone 30% or 40% unless you don't need equity market growth which is not meant to be a smart-alecky comment, not everyone does.

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