Is Now The Worst Time To Own Index Funds?

Understanding and avoiding the drawbacks of index funds.

Jason Zweig posted a column titled Index Funds Rule The World, But Should They Rule You? The basic idea is that the index trade might be getting crowded, so it might be a good idea to go against the crowd some with individual names and perhaps some other ways to access equity exposure.

First, I will say that using indexed products is perfectly valid. At times, like recently, they will be the best exposure but at other times they will not. Like any path to equity investing, there are also negatives. As the cycle goes on the broad indexes like the S&P 500 have the tendency to get heaviest in the most expensive stocks. That was true in 2000 with tech, 2007 with financials and might be headed in that direction again with tech now which is at about 24% of the S&P 500 which is high and worth paying attention to.

If the FANG stocks and a couple of others continue to outperform then tech will grow into a larger weighting. Are there signs of excess with these stocks now? Depends who you ask but trend is certainly toward excess if we are not there now. If/when FANG and other big tech rolls over then investors owning S&P 500 funds will be most exposed to that downturn, probably not realizing how much they had in FANG, and will feel the full brunt of that decline if they have no strategy to take defensive action.

We will spend a lot of time on portfolio construction here as an ongoing thread, but I mostly use a mix of individual stocks and ETFs that track sectors or industries. The willingness to go narrower than SPY, IVV or TOT allows investors the ability to better manage those overweights or just avoid some segment of the market they don’t like for whatever reason.

A good example of this might be with financials. I am not crazy about the big banks, haven’t been since before the crisis started. I sold Bank of America they day after they bought Merrill Lynch when they could have waited a day and bought it for much less. Many years later I owned Wells Fargo for a while but sold around the scandal involving fake accounts. I’ve owned Brookline Bank (BRKL) for quite a few years, Bank of Nova Scotia (BNS) since 2004, Blackrock (BLK) for favoring the ETF space and CBOE (CBOE) for liking the exchange business. That sort of allocation looks nothing like the Financial Sector SPDR (XLF). None of those names are in the top ten of XLF and the top ten accounts for 54% of XLF.

Not all of the names I hold are easily replicated by buying an ETF instead, maybe none of them are. There are a few small bank ETFs including a community bank ETF from First Trust that might be similar to BRKL. I am not aware of any Canadian bank ETFs, I just wrote about the ETF ETF which trades under symbol TEFT, that one is much broader than just ETF providers but I think is a useful product and the Capital Markets ETFs out there are much broader than just the exchanges. Someone who likes the big US banks could find several ETF proxies including XLF.

A bigger picture concept is the idea that a portfolio doesn’t only have to be index funds or just common stocks and while that seems like common sense, a lot of investors seem to frame it as owning just one type of vehicle which has never made sense to me, it is not logical than one wrapper can the be best for all things.

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