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Commentary: Market may soon prove that not all index funds are winners

Chuck JaffeChuck Jaffe ·

In a world where low-cost index funds and ETFs are attracting the vast majority of money being invested, one leading investment researcher is wondering if fund investors are about to “get what they pay for.”

David Trainer of New Constructs Inc. in Nashville, Tenn., says investors are confusing diversification for due diligence, buying into passive investment strategies that hold a lot of stocks without the least concern for whether those stocks are any good.

The popularity of passive investment strategies and the market’s long-term positive trend has masked the fact that investors are holding a lot of stocks that are mediocre or worse. That’s a problem for long-time holders rather than short-term traders or technical analysts, but it’s an issue for everyone if it leads to a flash crash or other major market adjustment.

The crux of Trainer’s message is that the proliferation of exchange-traded funds (ETFs) and passive investment strategies has led to dumb investing, where money flows into funds while turning a blind eye toward rational capital allocation and the relative value of the underlying stocks.

“What we are seeing is an over-reaction to the ineptitude of active management, where people are now doing the opposite and paying zero attention to the relative value of stocks,” Trainer explained. “The way they are acting, it’s as if diversification is the only investment strategy.”

Trainer does have an iron in the fire on the subject; New Constructs evaluates securities on a scale of “most attractive” to “most dangerous.” It extends that analysis to funds and ETFs by examining the securities in the portfolio; that’s the step that Trainer suggests most investors are ignoring now as they rush headlong into all types of passive investment strategies.

Since the turn of the century, roughly $1.5 trillion has flowed out of actively managed mutual funds, with virtually all of it going into ETFs, most of which are based on some type of indexing strategy.

Trainer isn’t suggesting that putting money into low-cost passive strategies is somehow a bad idea; he continues to believe that the only reason an investor should pay an expense ratio higher than the benchmark ETF is for a manager who can deliver superior results. Those managers are hard to find, which is why index issues are thriving.

But Trainer notes that index buyers are putting a lot of their money into potentially bad stocks. It is the difference, he said, “between just buying stocks – any stocks you can get for your money – and buying the stocks that most deserve your money.”

No index fund will be filled with only attractive stocks at the time an investor buys it, but recent research from New Constructs showed that the SPDR S&P 500 ETF (SPY) had one-third of its capital dedicated to stocks getting a rating of attractive or better, while just under a quarter of its assets went to stocks getting a dangerous rating or worse.

By comparison, the iShares Russell 2000 ETF (IWM) had 36 percent of its capital in stocks carrying a rating of dangerous or worse, and just 16 percent in stocks the New Constructs’ system labeled as attractive.

New Constructs examined dividend-focused ETFs and found that the funds in the category vary widely; an investor looking for a “dividend-oriented fund” could wind up with an issue holding as few as 46 stocks or as many as 680. Their allocation to attractive stocks could be as high as 40 percent, or as low as 14 percent, and the exposure to dangerous issues ran from a low of 7 percent to a high of 27 percent.

It reminded me of the go-go times of the 1990s, when index investing was first taking hold on a widespread basis and critics of active management spouted a statistic about how 88 percent of all active managers couldn’t beat the S&P 500.

At the time – based on some very specific parameters – that was true.

The problem was that the S&P 500 at the time also was outperforming 98 percent of the indexes then being tracked by Morningstar Inc.

In other words, index investing by itself did not guarantee performance; you had to buy the right passive investment.

That has never been more true than it is now, according to Trainer.

“We all know that stocks aren’t all equal, yet by ignoring valuation we are basically treating them all the same, and money is flowing to stocks whether they deserve it or not,” Trainer explained. “We’re creating a disconnect between real value and market value, and at some point that has to correct, and it could be ugly when it happens.”

Think Flash Crash kind of ugly, Trainer said, the kind of event that scares people back into doing due diligence.

There’s no telling when it will happen or the magnitude, Trainer said, but the market is building up an inefficiency, and those don’t last forever; eventually, the system corrects.

“People right now think they can buy an index fund and they will make money basically all the time,” Trainer said. “They need to come to grips with the fact that there are no simple, one-size-fits all solutions, and there is no replacement for diligence. … Someday, they will find out that buying index funds wasn’t enough; they needed to buy the right index funds.”

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   Chuck Jaffe is editor at RagingBull.com; he a nationally syndicated financial columnist and the host  of “MoneyLife with Chuck Jaffe” (moneylifeshow.com). He does not trade ETFs, and does not hold shares in any ETFs mentioned in this commentary. You can reach him at chuck@ragingbull.com.

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