As an adviser who allocates a large portion of client assets to low-cost index-type ETFs, and who manages a fair amount of my own portfolio in this manner, I believe that the trend toward lower-cost index-type investing, – I hesitate to call it “passive” investing, – is generally a welcome one. I say this because research has shown that lower-cost funds exhibit much lower “behavior gaps” than higher-cost alternatives, which means that investors seemingly are moving in the right direction as far as improving their dreadful record when it comes to investment performance.

That being said, I do think that, like anything else, there are correct and incorrect arguments being made in favor of index funds. Before I go further, I want to be clear that when I speak of index funds, I am referring to the garden-variety market-capitalization weighted funds such as those which track the S&P 500 index, or, for foreign equities, the MSCI Europe, Australasia, and Far East (or “EAFE”) index. These seem to be among the most popular, and, though I haven’t the data to support it, I would assume they are also the leaders, by far, in terms of assets under management.

So, to begin, I visited the website of indexing advocate Vanguard Group, which is becoming the colossus of asset management. On their site, they have a page dedicated to the advantages of indexing, and here a few they list:

  • Low expense ratios
  • Tax efficiency
  • Risk control
  • Diversification

With net expense ratios for many index funds relentlessly pushing toward zero, there really is no argument that cheap market exposure is a definite positive for index investing. Short of some sort of DRIP (“dividend reinvestment plan”) plans, which may not charge investors for participation, index funds are probably the closest one can come to investing for free. I think that this cost advantage is the primary driver of fund flows to index managers. I think that Dr. Ed Yardeni summed up this trend well when he wrote that investors are “seeking out low-cost funds rather than cheap stocks.”

Regarding tax efficiency, most evidence points to a huge advantage of index-type funds over actively managed funds. Even though in the U.S. only about one-fourth of equity holdings are subject to current taxation, for investors whose investments are subject to taxation, tax inefficiency is a very real drag on investor returns, and for these investors, index funds seem the logical choice.

It is worth noting, however, that they are not the most efficient choice. I ran the numbers on three of the most popular index-based ETFs, and I was surprised how high the tax drag can be on even the low-cost, low-turnover index-tracking ETFs:

indexing

Indexing

In this illustration, the assumption is for long-term (meaning longer than one year) holdings, and, for simplicity’s sake, a married couple filing jointly. In the United States, qualified dividends and long-term capital gains are not taxed for investors in the 15% marginal bracket and below, so that explains the null tax drag.

However, for those in the highest bracket, the annual tax drag can start to approach one-half of one percent annually for the S&P 500 ETF ($SPY), and for the Dow Jones ETF ($DIA), presumably due to their higher dividend yield than $QQQ, which tracks the tech-heavy Nasdaq 100.

For tax-conscious investors, tax-efficient allocation is paramount. Investors subject to the higher tax rates on dividends and capital gains should make the effort to allocate accordingly. For example, assuming non-dividend paying growth stocks are also owned within a given portfolio, it would make sense to own those in a taxable account, leaving the tax shelter of qualified accounts for the higher-yielding index funds. Unfortunately, in a graduated tax regime such as that which prevails today, it may be convenient to embrace a passive investing ideology, but it is likely to your benefit to be more active in terms of the taxable aspect of your allocation.

When it comes to “risk control,” Vanguard writes that “[i]ndexing eliminates the risk that an active manager will select securities that underperform the market. This is especially true with strategies that target broad-market exposure.”

This argument, in all honesty, seems a bit of a stretch. Sure, there is plenty of literature and research that attempt to demonstrate the futility of picking stocks, and so the logical conclusion is seemingly to own all the stocks, and to let the market sort it out over the long run. This would be a good idea except that the committees that populate their indices are oftentimes no better at stock picking than much-maligned active fund managers. There is real potential that the more choosing they have to do, the less effective indexing could become.

Here’s why I say that: As we have written before, one of the key factors that I think justifies a premium for U.S. equities is the unmatched dynamism of the market. Leadership and composition are constantly changing, so investors in the U.S. are not banking their “stocks for the long run” mantra on the same handful of stocks that seem to characterize most other markets around the world.

But churn in the S&P 500 is approaching such a pace that if it were to continue at this rate, roughly half of the S&P 500 components will be turned over in the coming decade. In fact, turnover within the index has become so frequent that it opens up index investors to the very real possibility that they are sometimes throwing out the good for the bad. This was one of the conclusions of Professor Jeremy Siegel and Jeremy Schwartz who, in a 2004 paper*, noted that the original S&P 500 components (the index was established in 1957) actually outperformed the index itself, and with less risk.

Because the S&P 500 is weighted by market capitalization, it runs the risk of adding large but expensive firms at the wrong time, which, Siegel and Schwartz note, is exactly what happened during the tech bubble of the 1990s, when large components such as Qwest and WorldCom were added to the index, only to lose 65% and 98% of their respective values subsequently. Conversely, the unloved S&P 500 utilities index, which had shrunk to only about 3% of the index composition at the peak of the tech bubble, has been one of the top performers since, outpacing both the technology index, and the S&P 500 itself. Sometimes, the market can be very wrong with its assessment of future corporate prospects, and index-only investors would be wise to heed the warnings of the past.

Finally, regarding diversification, Vanguard argues that indexing insulates investors against the risks of owning too few stocks, or too narrow segments of the market. I’ll concede the point that owning a pool of stocks is less risky than owning a handful of individual stocks, but it is highly debatable that index funds give you sufficient diversification. For starters, I have already noted that the S&P 500 already has a huge correlation with technology stocks, so index-only investors are basically staking their futures on the prospects of American technology firms continuing to dominate and grow.

Yet the point goes quite a bit deeper than that. Does

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