Are Index Funds Fads?

If you don't read The Wall Street Journal, you've been missing out. It's done an outstanding job covering the accounting scandals that are shaking up corporate America. Even so, not every article is beyond reproach, as one piece in Tuesday's Journal shows.

Headlined "Market's Fall Discredits Many Investing Rules; How to Respond," the article, which was a Journal roundup in the "Personal Journal" section, sets out to debunk some important axioms. For the most part, however, these aren't rules any slightly informed investor would have advocated, but I'm sure a few folks would have agreed with them. For example, we learn that buying on dips is bad, although I'd argue it beats buying on peaks. Another one debunked is the theory that "stock-picking is fruitless." If that was a widely held belief, then why did Janus get so much inflows in the late 1990s?

But the one that really amazed me was the section on index funds. "Like momentum investing and day trading, indexing became a fad among investors in the 1990s, and fads are doomed to die," the article asserted. Say what? First off, popularity doesn't make something a fad. Cars are popular. Does that mean they're a fad that will die?

Although many have given up on day trading and sold their momentum funds, index funds are doing just fine. Vanguard continues to gain market share. Owning a broad index fund hasn't been a day at the beach (with the exception of bond index funds), but their diversification helped to tame losses. That, in turn, helped investors to stay in the ball game. It's the frightfully volatile funds that have lost three quarters of their value that are causing permanent damage to investors' portfolios.

The article says the problem with indexing is illustrated by the fact that the S&P 500 owned Cisco (CSCO) at its peak in March 2000, thus highlighting the flaws with passive investing. The catch with that argument is that Cisco was also one of the most popular holdings among actively managed growth funds at that time. In addition, a broad index fund offers adequate diversification to keep from getting burned by a single stock. At the end of June, the largest holding in the S&P 500 was Microsoft (MSFT) at 3.25%.

Now, for the goofiest argument of all. The Journal heated up one of the oldest and lamest anti-index arguments around: It found 10 active funds that outperformed the Vanguard 500 over the past 20 years. All you had to do was pick one of these 10, and you'd have done better. Big deal. By definition, an index fund isn't going to be the top performer. The goal of index-fund investing is to get above-average performance without the difficulty of predicting which funds will be the top performers.

In 1999 I wrote about Berkshire Hathaway (BRK.B) in a favorable light. (I know it was a really gutsy stance. Next I'll come out in favor of apple pie.) A reader took offense and wrote to say that Warren Buffett is an idiot. "You'd have gotten much better returns if you had simply bought Cisco, Microsoft, and Intel (INTC) in 1990 and held on." I wrote back to ask if he had, in fact, bought those stocks in 1990, and he said, "No, but that's not the point."

I'm not saying index funds are flawless or that you should avoid active funds. Most of my portfolio is actively managed, but I think index funds are an excellent option for investors. They're really the opposite of faddish because something will always be performing better and will promise to ride the current wave forever. Three years ago it was Internet funds, and today it's bear-market funds. Index funds are tremendously boring, but the good ones get the job done.