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Index funds were revolutionary. They were founded by John Bogle forming a new tool of investing that gave an edge to common investors: inexpensive passive investing in broad markets. Investing into broad markets allowed investors to own equities without having to know too much about the assets. Investors could own a few shares of an index fund and as long as the broad market does well, the investor will have returns on their investment. However, index funds have come under fire for multiple reasons. Some even believe that index funds are scams. In this post I will address whether index funds are good investments with a rearrangement of the world.
Common Ownership Is Encouraged By Index Funds
It is commonly believed that investing into an index fund is the purchase of multiple fractional shares in a single purchase. Index funds are not that simple. The concept is that the fund you invest in is part of a firm or company. The money invested goes into a pool that invests into the shares that make up the fund. In other words, you don’t own the companies, you own the shares of a fund owned by a company that owns the shares. Despite these…complications index funds could still be good investments.
Why do I bring this up? What is the idea of free markets? Competition. The idea is that there would be multiple companies which produce the same or similar products that must compete for consumers by lowering costs or improving quality of their products by means of efficiency and innovation. Now I have a good question. What if those multiple companies are owned by a small handful of investors or companies?
That changes things. If a single investor owned multiple companies that produce similar products there would be little reason for them to chase efficiency and innovation as long as people are buying their products. In fact, they could potentially do many things that would form monopolies or trusts. For instance, let’s say three investors own all the energy companies in the world (I wrote this as an exaggeration, but I would not be surprised if this is ultimately true). These three investors could come together and agree to fix their prices so they can profit very well on this.
Anti-Trust Laws May Not Be Enough
There are many anti-trust laws that are designed to prevent this. However, I still see many issues with this. Every system has flaws which allow many wrongs past. Also, bias can easily sway enforcement of anti-trust laws. The government may decide that at certain times anti-trust laws may be ignored to keep certain industries afloat and investors happy, especially during a crisis.
Since many companies are mostly owned by index funds the interests may be a bit skewed. I could see situations where large investors try to push for decisions that would allow for the short-term gains. Keep in mind, some companies “too large to fail” including Enron were in the S&P 500 and feel drastically due to some…sketchy activities, not all companies in the S&P 500 have integrity. It is possible some investors may try to make decisions to hide unethical activity in order to attract investors and profit off companies that will not survive long. With the current Coronavirus crisis on hand it is safe to say the tides have pulled out and we will see who is swimming naked as Warren Buffett would say.
I would not consider myself an expert on seeing which companies would survive after the crisis. However, I did see signs of crisis for some companies before the Coronavirus crisis. If you invest in an index fund now, you may be subject to losses caused by a sudden loss or even closure by one or more companies in an index fund later on.
Index funds may have been a great tool to democratize investing. They allowed many people to invest in the stock market who would not have been able to otherwise. But John Bogle stated shortly before he died that index fund investing may be a tool to turn investor interest to the very few. While investing was democratized, corporate interests may have been un-democratized.
Are there substitutes? Excellent ones. Actively managed funds. Individual investors do not make corporate decisions when invested in actively managed funds. But actively managed funds do have multiple managers which can keep interests out of the very few. Actively managed funds have higher fees than index funds. But I know many with expense fees very similar to index funds.
It is unfortunate that index funds may no longer be the best tool for investing within broad markets during a crisis. However, shifts in investors and interests may be all it takes to make index funds a better investment.
Do note that I am primarily invested in actively managed funds, but I have obtained promising results from them. Take my advice, but take it with some salt as you forge your wealth.