When Paul first started this show, indexing and target-date funds were not very popular at all, as the world experienced a decade where large U.S. companies struggled to generate any returns for investors. Fast forward another decade, and indexing and target date funds are now all the rage as investors believe that “indexing” is synonymous with great returns, low fees, and wealth in retirement. Indexing may sound like diversification, but Paul explains what really happens when millions of investors choose this path for their portfolios. Later in the episode, Paul shares where fund companies make the biggest mistakes with indexing and provides a blueprint for capturing market returns that won’t leave you overweight in a few companies.
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Advisory services offered through Paul Winkler, Inc., an SEC-registered investment adviser.
Paul Winkler: Welcome, this is “The Investor Coaching Show,” and I am Paul Winkler. We talk money and investing, retirement planning, getting ready for that period in time when money’s working for you and you are not working for money, and we do it from a perspective of a group of people that don’t get involved in the sales of financial products, unlike so much of the industry.
That’s what I like to do: bring things from a little bit of a different perspective around here than you typically hear, and that’s what, of course, I will do. And I talk about the news of the day, what’s happening in the financial world. There’s a ton of stuff.
Man, Nik and I were talking about this. You’ve got everything, from policies being talked about in Washington, and of course, you’ve got Minneapolis, and people keep talking about that and how that affects things.
But yeah, I have got some interesting stuff that I’ve been talking about with other people this week. Things that could be pretty earth-shattering in both good and bad ways. I don’t use this stuff to predict where markets are going to go.
I was talking to one of my longtime clients this week, and he and I got back and forth, and he’s a doc. And he was talking about, he says, “I have tried so hard to send people to you guys, and so often, what they’ll do is say, ‘Well, I can’t just capture market returns. I’ve got to beat the market,’” and he says, “I try to tell them, ‘Good luck with that.’”
And I say, “Yeah, the odds are like 97% of professional managers with small company stocks can’t beat the market. Over the last 15 years, then you have like 94% of professional managers with large companies can’t beat the market. Good luck, if the professionals can’t do it, you doing it.” And he says, “Yeah, that’s what I tell them.”
And I said, “Yeah, a lot of people don’t recognize what markets have returned historically,” and a lot of times, it’s because they’re focusing on the results that they’ve seen with themselves and, a lot of times, they just don’t know. And they think where returns come from is their really great prowess at figuring out which markets are going to do well next.
The point that I always make is that, if you’re buying something, somebody else is selling it. If you’re selling something and somebody’s on the other side buying it, money is going to be wrong. And they don’t recognize it as gambling, but it is gambling with investment.
And we talked about returns historically. I kiddingly say, “You have no idea how many people had $100,000 in the 1970s that don’t have $60 million today.” I joke around about that.
That’s what markets have delivered. But people who are trying to get a higher return than that, you might as well perish the thought.
This is going to be something I want to talk about, because typically, people hear this particular message. They hear this message that you don’t want to try to beat markets, because people, even the professionals, have not been able to do it, and it is futile to try to do this.
And one of the things that I point out is that markets have delivered returns that are pretty respectable throughout history.
Now, one of the messages that people take away from this, however, is that you just index the portfolio, and that’s how you implement this. Now, I started this radio show 25 years ago. We’re coming up on 25 years. Is that not crazy?
But 25 years ago, that was my message. It was something that I didn’t hear anyplace else. I didn’t hear it hardly any place.
And it was one of these things that people heard me talking about it, and people in the Chamber of Commerce, which I was really super involved in, I was chairman of the chamber, people would hear me talking about it and go, “You need to be on a radio show. You need to be talking about this on the radio.”
Of course, that’s how the show started. I started looking into that, because I thought, I was intrigued, Yeah, that’s a neat idea. Well, the message was pretty unusual back then, and things really took off as far as people listening and the amount of people that were intrigued with this idea.
And I’m not going to say that I had the least bit to do with this, except for that there were probably other people, there were a lot of other people seeing the same stuff that I’d been seeing as an investment advisor, but this whole movement toward indexing took off. Now, that wasn’t what I was talking about back then, or now, but that is the takeaway, and the investment industry started pushing this like crazy, the idea.
Because you had guys like John Stossel, who was out there throwing darts at the stock tables, and he’s beating the professionals and he’s interviewing people like Burton Malkiel from Princeton and going, “What’s going on here? Why am I beating these?” And it became pretty well-known that monkeys throwing darts at stock tables, they were doing better than the professionals.
And then what happened is, of course, you had this period of time, and it didn’t really take off. And the reason it didn’t take off right away is because, what do people think of when they think about investing in the stock market?
Now, why did it not take off? And all of a sudden, I’m going back 25 years, because we had the dead decade. And when people think about the stock market, they think about large U.S. growth companies. But large U.S. growth companies, when I first started this show in 2001, they were in a world of hurting, because you had the tech bubble bursting and you had these things going down.
They went down 9% in 2000, 12% in 2001, and another 22% in 2002. Nobody’s going to sit around there and talk about that and go, “Man, that’s admirable. I want that.”
That’s not what’s going to happen. Nobody’s going to sit around and go, “Man, that is exactly what I want my investment portfolio to do.”
Then 2003 through 2006 was okay, 2007, we started to see the cracks, 2008, abysmal, right? Early 2009, really, really tough. And 2009 ended okay, because we came out of that mess, the banking mess, and all of that, but it was a rough patch.
Literally, until about 2012, it was a rough patch, where this area of the market was doing nothing. Now, you had target-date funds coming along really strong, and companies starting to open up these target-date funds in that period of time.
In 2009, though, 2010, nobody wanted them. I’m telling you, I would be talking to people about this stuff, and I wasn’t a fan either, because of their lack of diversification. Still, they have a lack of diversification. They’re very, very concentrated in big companies.
But here’s what happened back then. I would be talking to people, and they’d bring in their 401(k), and they’d say, “Hey Paul, what do you think? What do you think I should be choosing in here?” But nobody was really focusing on target-date funds at all.
I’d go, “Are you using the target-date fund?” “No, no, no, no, no, no.” And why they weren’t using the target-date fund was because of the abysmal performance of large U.S. stocks, which they were concentrated in.
I never had any problem talking people out of using those types of platforms in their 401(k)s. Because if you’ve listened to me, you know that my thing is, as much as I possibly can, they will give you other choices in your 401(k), typically. And they’ll give you lots of other choices, because they don’t want to be responsible if, 20 years down the road, you have a lousy balance in your 401(k) and it’s as a result of their overconcentration of that portfolio in a small number of things.
That’s the idea behind this. You spread it around a whole lot more, because you might go 10 years with no return in large U.S. stocks, like we talked about.
In that same period of time, you might have a quadrupling in value in international small companies, which is basically what happened, and you don’t know when that’s going to happen. You might have a 20-year period. And there have been periods like that that have been extraordinarily long, where large U.S. stocks just did nothing.
Typically, what I’m doing is I’m choosing from these other things that you have access to, but back at that point in time, it wasn’t hard. Now it’s extraordinarily hard to get people to do that, and the reason is that large U.S. stocks have had a bit of a run that has been pretty decent. Not the best, but most people don’t know what the best has been, because they don’t track anything other than large U.S. stocks.
But because it has been reasonable and hasn’t lost money, like it did from 2000 through 2002 and again in 2007, 2008, because it hasn’t had that loss, they feel pretty bulletproof about it. “Hey, all this stuff is doing well, the targeting funds are doing well, let’s just do that.”
Well, The Economist is a British publication on economic issues. They had an article this week, and it was entitled “Is Passive Investment Inflating a Stock Market Bubble?” That was their question.
And they said, “In 2016 researchers at Bernstein, a broker, published a note entitled ‘The silent road to serfdom: why passive investing is worse than Marxism.’” That’s a little bit of an overreach, but anyway, it says, “A decade later the revolution is in full swing. Trillions of dollars of capital have poured from actively-managed investment funds into those that simply track market indexes, and the flow shows no sign of stopping. As much as 60% of net assets overseen by American equity funds are in such passive vehicles, estimates the Investment Company Institute.”
Now, the part that’s being missed here, and this is something I’ve talked about before, is that these passive vehicles are now being actively managed. You have a fund that’s tracking the S&P 500, let’s say, and people are buying it, they’re selling it, you have intraday trading of it, they’re buying inside, they might buy it at 10:00 a.m. and they sell it at noon, or whatever, or you’ll have trading of the portfolio throughout the course of the year.
They’ll increase a little bit more in large U.S. when they think large U.S. is going to do well, and they decrease it a little bit, and maybe they increase a little bit of international, or something like that, international large Europe, Australia, Far East, or something like that. When they think that’s going to do better, they’ll increase that, and it is a form of market timing still.
That’s really one of the things I think that they’re missing here. But anyway, they’re saying that a lot of assets are going that direction, and this is making active managers a little bit upset, is really what they’re saying. They’re saying, “What investor does not know that most active managers fail to beat their benchmark index, while the passive alternatives hug theirs closely and charge rock-bottom fees?”
They’re saying that they’re starting to get the gist of that, is really what the article is pointing out. They’re starting to get the gist of it, that the passive market index is beating the professionals, and they’re charging less. And that is what they’re saying is, “This is what’s attracting investors.”
Low cost and we beat the professionals, and it’s true in large U.S. stocks. That’s exactly what you’re seeing.
Now, what happens is that people get that message even more strongly when you’ve had a good run in that particular market segment. Since “their indiscriminate buying could therefore pull share prices out of whack with underlying earnings.” In other words, what you’re buying when you buy stock is you’re buying the company’s earnings, you’re buying the present value or you’re paying the present value of all the future earnings at a certain rate of return.
The way I like to explain this simply is this: Let’s say that if I have a company that has $1 of earnings that’s going to walk in the door exactly one year from now, and then the company’s going to close its doors, it doesn’t have any assets, it’s just going to close its doors. Let’s keep this super, super simple.
And let’s say that I’m trying to figure out what to pay for the right to receive that $1 of earnings one year from now. What I will do is I’ll go, “Okay, what rate of return do I need?” Based on the risk, I need about a 10% rate of return.
“Okay, so what should I pay today for the right to receive $1?” The answer would be 91 cents, because 10% of 91 cents, 10% is another nine cents, right? Ninety-one plus nine is $1. Okay, so that’s where I get my price for what I’m going to pay.
Now imagine it’s infinitely more complicated than that, that the earnings are going to be up to one year and maybe going to be down the year after that, because things are probably going to slow down, and I’m looking out at my tea leaves and I’m trying to figure out what’s going to happen in the future. And investors are, as a whole, doing their best to try to figure out what those earnings are going to be, what the growth rates in the earnings are going to be.
How much are the earnings going to grow? It’s not going to be just $1 a year from now, but it might be $1.50 the year after that, or whatever.
And we’re trying what we can, as best we can, to figure out what the earnings are going to be and pay a price. Now what they’re saying is that, because people are just … there’s a demand and they’re buying, they’re buying, they’re buying, they’re buying, they’re indiscriminately buying these companies, and they’re pushing their price up above what the earnings actually merit.
What we’re seeing, we saw this in the late ’90s, and I’m not going to say that I agree necessarily that they’re disproportionately pushing the prices up.
The other pros can’t do it, I can’t do it either. It’s the height of ego to think that you can.
But anyway, so they’re saying that they’re pushing it up, and is that possible? Yeah, well, we found out in hindsight that the late ’90s, it’s exactly what was going on. The prices were going way the heck up.
And they’re saying that “pulling in the opposite direction are the arbitrageurs, such as hedge funds, which can take the other side of tracker funds’ trades and profit from bringing prices back into line with fundamentals.” In other words, a hedge fund might go in short.
That’s where you benefit economically from betting that a stock is going to go down in value, and you have people on the other side. That’s why markets are hard to predict, because you have somebody that believes it’s going to go up, but on the other side, you have somebody that believes it’s going to go down.
But let’s just keep going with this, because if we look at this, we say, “Well, they ‘have a far weaker effect than is commonly thought,’” they’re saying right here.
What they’re saying in this article is that the demand for indexing is driving things disproportionately up too much, and on the other side, the arbitragers, they can’t necessarily bring it down, they can’t bring it back into where it should be. It’s insanely complicated, but it’s insanely interesting to me, that they’re making this point.
What they’re saying is that “an investor who buys $1-worth of stocks using fresh cash (or the proceeds from selling other assets such as bonds),” they push up the aggregate market value. And in this study, they’re saying it can push it up by $3-8.
And that might be what the overpricing is regarding all of this. Now, what happens is that they’re saying that the number of shares in existence doesn’t change, but the demand for them has risen.
Now, after this break, I’m going to walk through how this plays out with fund companies and where I actually tell people, “Hey, you know what? This is why I don’t use indexing, except for in a couple areas of the market. I don’t do it because of this problem.”
And people think, “That’s what you’re teaching, is just buying.” No, it’s problematic, and I’m going to walk through what I actually look at when it comes to investing after this.
All right. Paul Winkler, “The Investor Coaching Show,” paulwinkler.com is the website where we have all kinds of video, all kinds of audio. The podcast lives there, and you can ask questions on the website on there and we’ll get back with you on that. You can go to the content section and ask a question right there.
Okay, so back to this article, “Is Passive Investment Inflating a Stock Market Bubble?” I talked a little bit about whether there is any kind of evidence to back this up, what’s going on there, the idea that buyers are overwhelmingly going that direction.
It’s something that I talked about 25 years ago. I’ve been talking about for a long, long time, how people trying to beat the market don’t beat the market. They just don’t.
And the people that do beat the market don’t repeat. It’s very, very difficult to do that.
And because of that, what’s happening is there’s this overwhelming flow of new money there. Now, it was the belief years ago that if this became the method of managing money, if really people just were passive all the time, then all of a sudden it would become possible to beat the market.
Now, Gene Fama, the guy that I studied under, won the Nobel for economics, basically said if all of a sudden everybody’s doing passive, markets would still be efficient. It would still be hard to beat markets because every time a trade is made, somebody’s trying to decide whether it’s worth buying at the current price, and the other side, the other person is trying to decide whether it’s worth selling at that price or if they demand more, and the buyer is trying to get the best deal that they possibly can.
But basically, what they’re saying in this article is it’s indiscriminate, that they’re just paying too much because the buyers are overrunning the sellers, let’s just put it that way. So they’re saying that there can be these inefficiencies.
And who knows? You don’t know except in hindsight. But the idea here is this: What is being overrun? Where is all of the money flowing?
This is what I started to talk about before is that most of the money is flowing into the biggest of companies because that’s what people are most familiar with. So you have tons of money flowing that particular direction.
And the active managers, the people that are trying to pick stocks and trying to determine which companies are better than others, are really frustrated because it’s hard for them to beat the passive, the indexes, in other words, because of this demand for stocks driving up the price, which is creating the performance being better with the indexes. And they’re saying it’s not because they’re bad stock pickers, but it’s because of this demand driving up prices.
And that is, it’s a little bit tenuous. That argument’s a little bit tenuous. But they do have a point in a way, so I don’t want to totally dismiss it. And this one study was, it was pointing out that.
But here’s what they talked about here. They said that in 2024, they had these estimates about money funneling into savings and Vanguard estimated that passive investments, that 64% of Americans of their pension pot contributions were going into target-date funds.
Now, their target-date funds are, they’re using what’s called a total stock market fund, and they have some money that goes into a total international stock market fund, and then they have various bond funds depending on the age the person is and how long before they’re going to retire. So Vanguard is making this statement based on what their experiences have been, and that’s the way their portfolios are managed.
Now, so for example, if you look at their total stock market index fund, you have about 3,500 stocks in that portfolio, 3,519 last I looked. And then you have the international stock market portfolio is 8,600, a little bit over 8,600 stocks in there.
So if I have an index fund with two stocks in it, and one is a $3 billion company, and one is a $1 billion company, and I put $4 into that stock market fund, they will put $3 in the $3 billion company and $1 in the $1 billion company, they will overweight the bigger company. And that’s what this article’s saying.
They’re pointing out that this is a problem. And this is something that I’ve talked about for 25 years, why I don’t use indexes in the vast majority of asset categories when I put a portfolio together, because of that issue.
Now what’s happening is that with that total stock market fund, you have 3,519 stocks in that total stock market fund. Forty-eight percent of your money is in 30 companies. I mean, half your money is in just 30 stocks out of 3,500 stocks.
And then on the international side, it’s not quite as skewed. You have 8,600 companies, but you have 20% of your money in just 30 companies out of 8,600. I mean, it’s just, wow.
So, another way of looking at it, one quarter of 1% of the holdings, the stocks, makes up about a third of the portfolio overall. And you go, “Whoa, wait a minute, that’s really skewed.” It’s literally one quarter of 1% makes up a third of the portfolio.
So you can see where they’re coming from and saying, “This could be really skewed. This could be problematic.” And historically, when this type of stuff happens, it hasn’t ended well, where people end up in these skewed positions, and all of a sudden those markets come crumbling down, or those few stocks that are at the top of the barrel, the biggest companies, when they come down, that’s a problem.
And again, we’ve seen that a little bit recently, where some of the smaller companies have actually been significantly outperforming larger companies, but people don’t have much exposure there. But here’s the deal, 83% of 20-year periods.
It’s like, you remember they had the commercials, “four out of five dentists think this,” right? Okay. So you think, Okay, four out of five dentists think this, so chewing this gum is a good idea.
They’re trying to tell you that’s probably a good idea to do this. I’m telling you, four out of five 20-year periods, small companies have a higher return than large companies, and that’s where people don’t have exposure.
Now, if we’re looking at value companies, which are also underrepresented, value companies are companies that have lower prices. So by definition, compared to book value or the assets of the company, in other words, if we’re underweighting those companies with lower prices, now we’re not looking at four out of five dentists, we’re looking at over nine out of 10 dentists, because 96% of 20-year periods, what we see is value does better than growth. And that is why when it comes to investing, I’m not looking at going and just indexing.
Large U.S. stocks, large international works okay, but when we’re dealing with value companies, we’re dealing with smaller companies, I want to have a fund that is more leaning toward the more value and the more small. And so I’m looking at the bottom 20, and it gets too complicated for me to teach you how to do it, but I’m looking at the bottom 20% typically in terms of price to book for value companies.
I’m looking at companies that are in the bottom 20% or so when it comes to size of the company. So I look at the whole market, and I go, the smallest 20%, that would be microcap, for example.
It gets a little bit more complicated, but I just want you to get that this message, it’s kind of like where you have these extremes in viewpoints on things. I mean, let’s look at political views or whatever, and you see that some people are all the way on one side on an issue, and you see another group of people all the way on the other side, and you realize, well, maybe neither one of them is really completely right.
Maybe there are some truths in the middle. Maybe there are some reasons to look a little bit beyond what you’re hearing the loudest voice yelling when it comes to investing, or when it comes to politics, quite frankly. Because a lot of time, there are truths in the middle, and there are reasons that people hold the positions that they do when it comes to politics, but there are reasons not to go with the extremes when it comes to investing, to oversimplify the investing process.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
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