Mutual Fund Investing Mistake #1: Index Funds Investing

[Vitai Slade]

WOW, just saw this on a website and HAD to share it with you guys. Taken from: http://investorplace.com/resources/7-mutual-fund-mistakes-to-avoid/#.UsaVXtJDtIE

Mutual Fund Investing Mistake #1: Index Funds Investing
Lots of people say that index funds are the only investment you need, but indexing is not the best answer. Take Vanguard’s 500 Index Fund (MUTF:VFINX), for example. It’s the family’s largest fund, with more than $100 billion in assets. In fact, it’s one of the largest mutual funds in the world.

But it’s not the safest index fund, nor is it the best-performing index fund. During the tech bear market, investors lost more than $40 billion with the fund. A little more than 18% of the fund’s assets are tied up in just 10 stocks and more than half of its top 25 assets are invested in just three sectors.

What do you think?

[Frankies Girl]

Meh.

The Vanguard 500 was the first index fund Bogle created. So it's based off of the total market from that time period. It is still a viable fund choice and does very well overall. I think the article is just looking for an angle or talking points since index fund investing is a specific style choice for those that don't want to spend hours a week buying and selling to chase a small bump in profits (and risk losing more overall as well).

[Khan]

Every asset class will have a period of underperformance. And a huge bear market crash is almost impossible for anyone to avoid, and saying that VFINX lost 40 Billion during the tech bubble popping, says nothing about what active funds lost.

That said, mutual funds always have an additional cost that they have to make up for, which is the cost of active management. It is most certainly possible for a hedge fund or a mutual fund to outperform, as it is for a manager such as Buffett or Peter Lynch. The problem lies in identifying them, in them having a small enough base that they're not actually "the market"(it's easy to be lithe and small at 50 million, it's impossible at 300 billion), and in management fees not destroying that wealth creation.

Also, a shitty website trying to hawk it's own product.

[Jamesqf]

The Vanguard 500 was the first index fund Bogle created. So it's based off of the total market from that time period.

I'm confused.  If it's an index fund, shouldn't its holdings reflect the current index, not what it might have neen 'way back when'? 

Even more confusing, how can it be an index fund if "A little more than 18% of the fund’s assets are tied up in just 10 stocks and more than half of its top 25 assets are invested in just three sectors."?  Unless of course the index is weighted that way.

[the fixer]

This is not the first time I've heard of people attack the S&P 500 and associated index funds and then say "see, all index funds are BAD!" Well yeah, the S&P 500 isn't that diversified and index funds based on it have become victims of their own success.

http://www.cbsnews.com/news/facebook-points-out-flaw-in-sp-500-index-funds/
http://www.cbsnews.com/news/formula-x-trounces-sp-500/

Another nasty one is that actively managed funds that hold mostly stocks all use the S&P 500 as their benchmark, so all you have to do to get long-term alpha is diversify with small cap. These people make a living off comparing apples to oranges and hoping no one notices.

[Frankies Girl]

The Vanguard 500 was the first index fund Bogle created. So it's based off of the total market from that time period.

I'm confused.  If it's an index fund, shouldn't its holdings reflect the current index, not what it might have neen 'way back when'? 

Even more confusing, how can it be an index fund if "A little more than 18% of the fund’s assets are tied up in just 10 stocks and more than half of its top 25 assets are invested in just three sectors."?  Unless of course the index is weighted that way.

Quote from the wiki:
At the time, the proverbial riposte to the observation that most funds underperformed the S&P 500 was "of course, you can't invest in an index." John Bogle tried to create a way in which an individual investor could effectively invest in an index. Index funds had already existed for a few years, but were only available to institutions such as pension funds. Having founded Vanguard as a broker-sold mutual fund company, he quickly turned the company into a no-load fund firm (meaning that the buyer pays no sales commission — called a "load" — when buying or selling fund shares) and in 1976 introduced his first index fund. This first index fund for individual investors, called the Vanguard 500 (which invested in the 500 companies that made up the S&P 500), has since out-performed many[which?] other competing large mutual funds.[5] Over $100 billion is invested in this mutual fund, and Vanguard has since created other index funds that focus on stocks in particular industries, countries, or companies of varying size (such as "small-cap" or "mid-cap" indexes).

So I meant that the fund tracked the S&P index part (I refer you to my signature if there is any more confusion).

[the fixer]

I think Jamesqf might have been pointing out the slight inaccuracy that Bogle created the 500 index fund because those were the only stocks available. As I understand it, he chose the S&P 500 because it was easy. The mechanics of large index funds had to evolve to allow replicating 5000-stock indexes, using techniques like index sampling to limit transaction costs.

At least this is how I understand it, but I too have no idea what I'm talking about more often than I'd like to admit.

[KingCoin]

Another nasty one is that actively managed funds that hold mostly stocks all use the S&P 500 as their benchmark, so all you have to do to get long-term alpha is diversify with small cap. These people make a living off comparing apples to oranges and hoping no one notices.

Technically this is adding beta, not alpha, but yes, you're right.

Overall, this original article is too stupid to really warrant a serious analysis. The sad part is, this guy probably knows better, and he's just conning the less informed into buying his newsletter which I'm sure is worth less than nothing.

[AtlStash]

You really do need to be careful with investing websites. Many of them churn out crap where the facts are manipulated to look the way the author wants.  Investorplace and Motley fool are 2 that are primarily in business to make money off of unsofisticated investors and advertising.  Quality research is not of interest to them. 
  The link below shows the actual holdings and sector information for the Vanguard 500. Towards the bottom is a link to the portfolio holdings which shows the true makeup.
  https://personal.vanguard.com/us/funds/management?FundId=0040&FundIntExt=INT
The S&P 500 is weighted as shown at this site: http://www.slickcharts.com/sp500.

If you compare the 2, they are very close.

[Jamesqf]

I think Jamesqf might have been pointing out the slight inaccuracy that Bogle created the 500 index fund because those were the only stocks available. As I understand it, he chose the S&P 500 because it was easy.

No.  I was asking two questions deriving from the link.  1) If it's an index fund, shouldn't it reflect the current makeup of the index, not what it might have been in the long-ago past?  2) If it's so heavily weighted in a few stocks/sectors, how can it be an index fund?

Per AltStash, the answer seems to be that the link author doesn't know what the heck he's talking about :-)

[beltim]

I think Jamesqf might have been pointing out the slight inaccuracy that Bogle created the 500 index fund because those were the only stocks available. As I understand it, he chose the S&P 500 because it was easy.

No.  I was asking two questions deriving from the link.  1) If it's an index fund, shouldn't it reflect the current makeup of the index, not what it might have been in the long-ago past?  2) If it's so heavily weighted in a few stocks/sectors, how can it be an index fund?

Per AltStash, the answer seems to be that the link author doesn't know what the heck he's talking about :-)

1) yes, the index fund reflects the current makeup of the index

2) yes, the s&p 500's top 10 components account for 18% or so of the total value of the index

[SnackDog]

Index funds - investing for the common man. Set it and forget it.  Definitely the best approach for the typical, clueless investor who would otherwise invest in stocks based on tips from his hairdresser or overheard at a party.

[marty998]

I think Jamesqf might have been pointing out the slight inaccuracy that Bogle created the 500 index fund because those were the only stocks available. As I understand it, he chose the S&P 500 because it was easy.

No.  I was asking two questions deriving from the link.  1) If it's an index fund, shouldn't it reflect the current makeup of the index, not what it might have been in the long-ago past?  2) If it's so heavily weighted in a few stocks/sectors, how can it be an index fund?

Per AltStash, the answer seems to be that the link author doesn't know what the heck he's talking about :-)

1) yes, the index fund reflects the current makeup of the index

2) yes, the s&p 500's top 10 components account for 18% or so of the total value of the index

Yes... index can be far from diversified. See below for the top 10 components of the Australian S&P ASX 200 (as at 16 dec). Having said that, our top 10 is a pretty decent set of companies. If you held these for the last 15 years you would have done very well, notwithstanding the carnage of 2008/09.

Security                                                 MktCap($)      MktWeight   Sector

Commonwealth Bank of Australia   $119,605,119,631   8.68       Banking
BHP Billiton                                  $115,139,126,114   8.36       Diversified resources
Westpac Banking Corporation              $96,380,497,579   7.00       Banking
Australia and NZ Banking Group             $82,996,588,076   6.02       Banking
National Australia Bank                     $78,354,276,293   5.69       Banking
Telstra Corporation                             $61,842,079,554   4.49       Telecommunications
Wesfarmers                                     $47,217,255,476   3.43       Consumer staples (mostly)
Woolworths                                     $40,957,805,984   2.97       Consumer staples
CSL                                                     $32,312,942,867   2.35       Biotech
Woodside Petroleum                             $31,102,627,302   2.26       Oil & Gas

Top 10                                                                              51.25%