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Are Index Funds A Threat To Your Wealth?

Michael Burry, the investment manager made famous in The Big Short, is claiming that index funds are in a bubble like the CDOs that led to the financial crisis. Is he right? Maybe or maybe not. Only time will tell.

If Burry is wrong, bailing out of index funds now can mean missing out on future returns until you summon up the courage to get back in and there’s no way to know when it’s “safe” to do so. If Burry is right, it takes an average of about 22 months to recover from a bear market. It’s not fun to experience, but it’s also not a calamity if you don’t actually need the money during that time. (This is why you should only invest money you don’t need for at least 3-5 years.)

What I do know is that investors have much bigger things to fear in the long run. These hidden dangers can cause lasting damage to your portfolio. Here are three of the most common:

I can't tell you how many times I've seen portfolios with huge concentrations of stock in one sector or even a single company. This is often because the owners of the stock don't even realize how much they have. Sometimes the stock was inherited. Many times, the person received shares of their employer's stock as a match in their 401(k) or they contributed money to a high performing fund (more on that later), not knowing that the fund was only invested in company stock.

In any case, the outcome is the same. The person is exposed to a significant amount of risk that they may not be aware of. A diversified mutual fund, like an index fund, can lose a lot of money in a market downturn, but an individual stock can go to zero and never come back.

That's why you don't want to have more than 10-15% of your portfolio in any one stock, no matter how good it seems to be. This isn't just a matter of personal opinion.  A financial advisor could lose his or her license for recommending some of the positions that I've seen.

This risk can be masked when a stock is doing really well. Just as individual stocks can go to zero, they can also appreciate much faster than a diversified mutual fund. But that doesn't make them less risky. Remember how well certain dot com stocks were doing in the late '90s?

People will often try to justify why their particular stock is "different," especially if it's a current or former employer. Behavioral economists talk about a "familiarity bias," in which we're psychologically predisposed to favor things we're familiar with. But the reality is that even a great company with a wonderful product can be destroyed by something completely unforeseeable. It could even be something that the company has no control over like a new technology or a change in the law.

This risk is magnified when it's your employer's stock. In that case, you could lose your job and a good portion of your nest egg at the same time. While there may be some good reasons to purchase some of your employer's stock like discounted pricing or favorable tax treatment of net unrealized appreciation, try to keep any holdings to no more than 10-15% of your portfolio or stick to diversified mutual funds.

Chasing Past Performance

Let's admit it. When we're choosing mutual funds, we all like to look at what the funds' track records are (or Morningstar ratings, which are also based on past performance). The problem is that past performance is a notoriously poor predictor of future performance.

For example, S&P releases a study each year examining the top quartile of different types of funds over a 5 year period and how they performed over the following 5 years. By random chance, there is a 25% probability that a given fund will be in the top quartile so you might expect that at least 25% of these top performers stayed in the top quartile. But in the most recent report, 0% of them did. In other words, these top quartile funds actually had a much lower chance than average of staying in the top quartile so you would literally have been better off picking funds randomly. (Previous studies have consistently shown similar results.)

A related mistake is running away from poor performance. If Burry is right and the market goes through another steep decline, many people may be tempted to bail out of stocks and cut their losses. However, this could turn a temporary paper loss into a more permanent realized loss.

It may feel safe to put your money in the top performing funds in a bull market or into cash and bonds during a bear market, but both are actually riskier than they seem. The first approach can cause you to lose more than you can handle during the next eventual decline, and the second could cause you to miss the rebound. Instead, put together a diversified portfolio based on your time horizon and risk tolerance and stick with it. Better yet, rebalancing your portfolio at least once a year back to your original target allocation can reduce risk and even enhance returns by forcing you to buy low and sell high.

High Mutual Fund Costs

While the previous risks usually make themselves known with a bang, mutual fund costs  chip away at your wealth little by little. The most visible mutual fund costs are upfront load fees, but a fund's annual expenses can cost you a lot more in the long run. In fact, low expenses have been shown to be the single most consistent indicator of superior future performance when comparing similar funds.

Less visible are costs that are incurred when mutual funds trade. Unlike load fees and expense ratios, these trading costs are not typically found in mutual fund prospectuses because they're not fees that the fund is charging you. However, they still come out of your return the same way. Examples of these costs are trading commissions, bid-ask spreads, and market-impact costs, which happen when a fund's purchase of a stock pushes the price higher and selling it pushes the price lower.

Although these costs are hard to find, legendary investor John Bogle has estimated the costs as 1.2 percentage points for every 100% in a fund's turnover, which is generally disclosed in its prospectus. Basically, the higher the turnover, the higher the transaction costs tend to be, especially for large funds (which have more significant market-impact costs) and funds that invest in more illiquid or thinly traded securities like some emerging market and micro cap stocks (which have greater bid-ask spreads). Taken together, fees and trading costs can easily eat into your return by 1% a year. That may not seem like much, but it really adds up over time. $100,000 invested over 30 years at an 8% average annualized return grows to over $1 million. At a 7% rate of return, you have almost $250,000 less.

We don’t know for sure if index funds are in a temporary short-term bubble, but we do know that concentrated stock holdings, performance chasing, and high mutual fund costs can devastate your portfolio returns in the long run. Ironically, one of the best ways to avoid these problems is to invest in a diversified portfolio of the same low cost index funds that Burry is worried about. Unfortunately, this strategy is way too boring to be the subject of a NY Times bestselling book or an Oscar-winning movie. You’ll just have to settle for this article.