Too Much of a Good Thing?

Since the first index fund, Vanguard Index Trust, was started in 1974 by John C. Bogle, the founder and now chairman of the board of the Vanguard Group, the debate has waged about the benefits of indexing over managed investing. Index funds are types of funds that track the components of a market index. The idea behind indexing is to provide broad market exposure, low operating expenses (because they are unmanaged) and low portfolio turnover (this can decrease expenses and taxes).

Along with Vanguard, Blackrock and State Street round out the current major providers of index funds either through no-load, low cost mutual funds or Exchange-Traded Funds. Exchange-Traded Funds (ETFs) are a relatively new investment development. The first ETF was the S&P SPDR (SPY), which was created in 1993 by State Street. ETFs differ from mutual funds in that they are historically linked to an index  and they trade on the stock exchange throughout the day between investors. They also typically have extremely inexpensive underlying costs. Mutual funds are bought and sold directly through the mutual fund family so liquidity is provided.           

Index funds have been around a long time but are really in vogue in recent years. According to Jason Zweig, the Wall Street Journal’s The Intelligent Investor, $409 billion has flowed into passive (or index) funds in the last year. Vanguard 500 Index Fund (VFINX) is the second largest mutual fund in the world. The aforementioned big three index managers have more than $4 trillion in total indexed investments and represent the largest shareholder in 88 percent of the stocks in the S&P 500 Index, according to Jan Fichtner, a political economist at the University of Amsterdam. With the large inflows come new critiques of the impact of concentrated ownership.

One such critique, a paper posted by Fichtner and his colleagues at the University of Amsterdam, purports that Vanguard, Blackrock and State Street back company management in most shareholder disputes thus benefiting corporations over smaller shareholders.

In addition to concerns about undue influence from the big three on corporations, concerns are mounting about concentrated ownership of the same securities. It harkens back to both the ‘Nifty Fifty,’ (50 stocks identified by Morgan Guaranty Trust in the 1960s, which included the fastest growing companies at that time) and the more recent tech bubble.

The Fifty included such stalwarts as McDonald’s, Coca-Cola and WalMart. It also included Eastman-Kodak, Polaroid and Simplicity Pattern (patterns for making clothes on sewing machines). The Nifty Fifty were seen as buy and hold stocks and investors piled into them. Price to Earnings Ratio, or P/E, is a valuation measure for stocks and divides the price per share by the annual earnings per share. At the height of the Nifty Fifty mania their PE stood at 42 compared to 19 for the overall market at that time. To put that in perspective, the PE on the S&P Index averages between 15 and 16. Everything went well… until it didn’t.

When the first oil crisis came along with soaring inflation in the 1970s, the Nifty Fifty went down in flames. For example, Xerox fell 71 percent and Polaroid 91 percent from their heights. The Nifty Fifty is a lesson in diversification, which bears repeating.

Yet, investors did the same decades later during the tech bubble. At its height, the technology heavy NASDAQ index touted a P/E Ratio of 200. From 1995 to March of 2000, investors piled into internet stocks to the exclusion of diversification. I heard the statement, “this time is different” and that due to the internet there was no ceiling on P/E ratios or stock prices.

As with any bubble, it burst. From its height in March of 2000, the NASDAQ fell 78 percent. Many dot-com companies failed due to lavish spending and growth at any cost mentalities. A few notable favorites: Boo.com, Kozmo.com and Broadcast.com. On a side note: Broadcast.com (an online television site) was founded by none other than Mark Cuban, who become a billionaire in the process of its takeover, along with two others. The company was purchased by Yahoo! which eventually shut it down after the bubble burst. It is ranked as one of the five worst internet acquisitions of all time.

The Nifty Fifty and the dot-com bubble illustrate the need for diversification and avoiding the lemming effect of everyone going into the same stocks. What is so different with the index funds universe? For instance, the S&P 500 is a market weighted index so it holds large companies in the United States and everyone invested in an S&P Index fund holds the same set of stocks and keeps piling into them. The growing concentration of investors in index funds is of concern and certainly something to keep an eye on.

As ever, diversification is key.