Paul Winkler: Welcome. It’s “The Investor Coaching Show.” Evan Barnard here with me already cracking me up.
Evan Barnard: There you go.
PW: What on earth are you doing, man?
EB: Earning my keep.
PW: Don’t do that to me.
EB: Earning my keep, brother.
PW: Boy, is it hot enough for you?
EB: Man, I’ll tell you what, I was out mowing at about 7:30 this morning almost. And yeah, it’s warm.
PW: Yeah. I was cutting, too, this morning. I feel your pain.
EB: That’s some of my best thinking time.
PW: Oh, me, too. Me, too. I like doing it.
EB: That’s probably years on the mower. Your head starts to wander. But I was also moving some stones. My lovely bride wants me to basically take apart where she was planting garlic, and now I’m using these 100-pound stones to build a fire pit that’s 150 yards away.
PW: Oh my goodness. Oh my goodness.
EB: And I was hauling these things thinking, how did the Egyptians build the pyramids? I mean it was just like, this is hard work just moving this stone, with a wheel and everything.
PW: They had a couple more sons, I think.
EB: Yeah.
PW: It’s Father’s Day tomorrow, so maybe you should have …
EB: Exactly.
PW: … had a few more.
EB: I’ll be in a wheelchair for Father’s Day.
PW: I think you are alright.
Looking at Track Records
PW: Because I was off at a financial conference this week, there’s so much to talk about. In and out of the news and just things from the conference itself, super stuff out there.
So I am sure that we will get to a lot of things. One thing that caught my attention — there were several things, Evan, that were, “See, I told you so,” that gave me the temptation to go, “I told you. I told you to pay attention to this.”
EB: Right.
PW: There were several of those this week and I thought I would give a little bit of this out there, and then cover a couple of questions that came in as well. So one thing that really hit me was in Market Watch. I don’t know if you saw this, but I love this, because so often what people think we talk about — let me build this up — we talk about here, getting away for 23 years, getting away from stock picking. Don’t look at the track record, three, five years.
I know you got something on track records there, which I can’t wait to get to because I have no idea what that article is about. But I thought it’d be really interesting to hear about when your track record isn’t even right or the track record isn’t even accurate.
So the whole idea that you typically hear is to look at five and 10-year track records when choosing funds, which just doesn’t make any sense because markets go up and they go down. What follows up? Down.
You’re buying after something has done well, but it sells mutual funds. And that’s just, “Hey, what can we do? How can we get people to pull the trigger and do what we want them to do?”
And there’s something about that, too, that I’m going to get to today. Another “I told you so” type of thing that I’ll get to, but I’ll save that.
So the idea is don’t try to figure out which company is going to do better than another.
Don’t ask me which. “Hey, what do you think about X, Y, Z stock? Hey, Paul, what do you think about this?”
And we’ll even tell people, “Don’t stock pick,” and then five minutes later they’ll go, “Well, what do you think about this stock?”
EB: Exactly.
PW: Have you ever had that happen, Evan?
EB: Yes, absolutely.
PW: I have it happen all the time and it makes me crazy.
EB: It does.
Stock Picking
EB: And I think the other thing, and this one doesn’t make me crazy, I think it’s more of a function, you’ve probably studied this on the psychology side of a client that owns a stock, views holding that stock differently as stock picking, at least in their own mind.
I think a lot of people picture stock picking as when you buy the stock. But that entire journey as the investor is stock picking.
PW: For sure.
EB: As long as you hold it, you’re stock picking.
PW: And you think about it because, actually, it lines up with another rule of investing: buy and hang on to stuff.
EB: Yes.
PW: And well, if I’m buying it, I’m hanging onto something that isn’t prudent, which is an individual stock because you have all kinds of non-systematic risk and you have risk in the system. For those of you who don’t know what on earth that means, which is the system, think of it as the ocean.
The ocean is a system that goes up and down with the tide, and the boats that are on it will go up in tandem with the ocean. The currents come up, the boats go up. And they all go up. Not just one goes up, they all go up.
And if they don’t all go up, that means one’s sinking. So what happens is, when the ocean comes up, that’s the system raising the boats.
Now, if all of a sudden we’re looking at a single boat and that boat sinks, that is non-systematic risk. That is not the system so much as maybe the boat got a hole in it and that’s why it went down, so that’s a different deal right there.
Now, that’s the thing that we get. When we get into the rules of investing, we often talk about that. So typically what people say is the answer is, well, don’t stock pick, don’t market time. What type of investment should we get into? And that would be an index fund.
EB: Right.
PW: So you look at that and “Okay, so I’ll just buy index.”
Index Funds Ruining the Stock Market
PW: Well, this article says index funds are ruining the stock market. What’s the title?
EB: That should be interesting.
PW: Yeah, this is good. “Passive investing is making market concentration” — and, again, this is a we told you so moment — “it’s making concentration worse,” says new research that we talked about 20 years ago. We talked about how this is the problem with indexing. I’ve said it for years, I’ve said it in all my books.
It says, “Index funds are great,” in this article, but it’s so much better when you can borrow somebody else’s credibility. They give you broad exposure to the entire stock market, maximum diversification, and minimal costs.
And that’s why they sell. It’s just like in the diet industry, they said, “Get rid of fat. Get rid of fat and you will be skinnier.”
Now I eat three boxes of Snack Wells instead of one chocolate chip cookie. And then, of course, you get lots of sugar, which makes you fat, right?
That’s the problem. The message, that sounds great. “Get rid of all your expenses. Just have minimal costs.”
But here’s the problem. It says everyone should have their money in index funds, right? That’s the thinking these days and it has a lot going for it. A low-cost index fund.
And I agree with that. Low cost is a good thing.
But you can’t myopically only look at the management fee because, as we often talk about, you have expenses in a lot of different areas that you don’t even know about.
EB: Right.
PW: You have, what are they doing with securities lending revenue? What are they doing with block trading? What are they doing as far as momentum? Are they doing anything with that to reduce expenses?
What are they doing with the reconstitution effect, which is a hidden expense? And if you don’t know what any of those things are, well that’s it. It’s too complicated. You can’t understand this, is what the investment industry tries to lead you to believe.
But if index funds are great for any individual, what happens when everybody buys them? Does everybody win?
Closet Index Funds
PW: That’s touched on new research written by finance professors. Wow, Jiang, I probably totally butchered that, Michigan State University, and Dmitri Vianos. Maybe I got that a little bit better.
EB: Doesn’t sound like either one of them lives in Nashville so you’re okay.
PW: You’re right. Just forgive me on that one. They argue that the popularity of index funds is helping cause one of Wall Street’s most dangerous features: The massive overconcentration of the S&P 500 and the market into a few mega-cap stocks like Apple.
“Numbers regarding index funds are amazing,” they said. It says in 1993, they wrote that passive funds — like an index fund would be a passive fund — invested in U.S. stocks managed 23 billion assets.
That was 3.7% of combined assets managed by active and passive funds and 0.44% of the U.S. stock market. So it was a tiny, very small percentage of money that was actually managed in this particular manner.
By 2021, the passive assets had risen to 8.4 trillion from 23 billion. That was 53% of combined active and passive and 16% of the stock market, which is not the whole market obviously, but that’s a pretty big jump. Now, from 3.7% of mutual fund money to 53% though, that’s the point here.
EB: Are they including target date funds in their definition of passive or are they only talking about index funds?
PW: I would assume that they are because they’re looking at underlying funds and a lot of the target day funds are funds of funds. So they’re going to look at the underlying funds when they’re doing the research.
EB: Boy, that just seems like a big number even for growth. That’s interesting.
PW: Yeah. Yeah, it is a big deal. Actually, the real change is probably even greater though, they think, because they’re looking at closet indexers.
It’s like when you looked at the Magellan Fund when it became a closet index fund because they were so afraid of selling stock that it would trigger taxes, so they didn’t want to even sell stocks. So Magellan, which was always known for active management, Peter Lynch ran that one, and they became a closet indexer. So they think it’s even higher than that.
EB: Well, yeah. One of the fun families that we see a lot that’s in a lot of 401(k) plans as well as a lot of, at least one particular brokerage firm, sells a lot of these funds.
PW: It starts with an A?
EB: Yes.
PW: And it’s American Funds?
EB: Okay, this was just Capital Group.
PW: No, you can. Go ahead. Yeah, that’s fine. Yeah, you’re right.
EB: You look at what those funds own and typically someone will have five or six of those, and of course, we look at the MRI of the portfolio and they all own the same stuff, and all of those to me are closet index funds, even though they’re actively managed.
PW: I would agree with that, yeah. I agree.
They tout active management, but if you look at it, there are periods when they’re outperforming a little bit and then underperforming the next period.
And you go, “Well, okay, so it’s going.”
The Real Risk of Index Funds
PW: You think about that, if it’s over performing, if a fund is over performing the market at some times, when the market’s going up, let’s say, and underperforming when the market’s going down, now you’ve got increased standard deviation.
EB: Right.
PW: You’ve got increased risk, which can be a huge problem that people don’t even think about. You go, “You need to make sure you consider risk in the investing process.”
Great. How do you measure it? Nobody asks that question.
EB: Exactly.
PW: They need to ask that question. But here’s where the real risk of the index funds is coming from, as they point out in this study. And this is something we’ve mentioned many times here on the show.
In the article, it says at this point, the so-called Magnificent Six … it went from Magnificent Seven, didn’t it, down to Six? I forget what it was, the other one. It was something four.
EB: I lost track after it was Fang and then it went to something else.
PW: Oh, yeah, it’s all over the place. Tesla seems to have vanished from the list alone to account for one-third of the entire S&P 500 by assets. One-third of it, the Magnificent Six.
EB: Wow.
PW: And that is something that we’ve talked about here. It’s just, you look at that and you go, “You can’t have that much concentration in just a few companies and not think that you’re asking for trouble when those companies turn a corner and they’re selling for super high prices.”
Now, what they recommend here in the article — or one of the things that they bring up — is it’s not an argument for selling the S&P 500 Index Fund. And I agree with that.
It’s not, “Oh, go sell everything out now. Don’t own anything in that particular area of the market.” But divide it up and make sure that you’re capturing other market segments.
Now, they’re talking about some small-cap indexes, but small-cap indexes have the problem that you’re overweighting big companies, so you’re still getting bad concentration in areas of the market you don’t want. But they’re talking about, well, you could do an equal weight index fund of the S&P 500, and that is a problem because an equal weight index fund, it sounds good from a marketing standpoint, but what you’re doing is taking 500 companies and having an equal amount of money in all 500 versus just way overweighting those big companies.
But the problem is this: Think about it. If you have one day that a particular company is one-500th of it, and then it’s going to be a little bit less than one-500th of it because it does poorly performance-wise, and another company that has done really well is taking up more than one-500th of the index, then you’ve got to sell stock in one and you’ve got to buy stock in the other. And now you’ve got all kinds of transaction costs and taxes.
So if it’s a taxable portfolio, you can have transaction cost trading.
So it doesn’t make a whole lot of sense to do it that way, but that’s just it.
Monetizing Problems
PW:
That’s what Wall Street does — if they figure out that there’s a problem with one way of managing money, they just go to a different problem.
They’re just really good at that.
EB: I think this was a business book I was looking at recently, actually I think it was from Dan Kennedy, an old Dan Kennedy book on thinking about Wall Street.
PW: Yeah. Strategic.
EB: That’s Dan Sullivan.
PW: Oh, that’s Dan Sullivan. Dan Kennedy. No, wait a minute. Who’s Dan Kennedy?
EB: He’s a copywriter marketing guy, direct response for small businesses and so forth.
PW: I got the Dan right.
EB: Proactive, a lot of infomercials he created way back in the day.
PW: Oh, okay. So I’m not familiar with him. Okay.
EB: But he was talking about Disney, and when you’re talking about Wall Street solving the problem with creating another problem, fees is where this is going. Disney had a problem of people complaining about long lines, so they charged for a program that says, “Okay, we’ll put you in the fast line.”
Disney monetizes their problems. If it’s raining, they’ll sell Disney umbrellas.
PW: That’s such a good point. That’s such a good point.
EB: Well, Wall Street has the same philosophy.
PW: Oh, that’s such a good point.
EB: When you were talking about the, not cap-weighted, but the equal-weighted index, people listening to that may think, Well, what do I care? That’s going on inside the fund. I’m not paying a commission.
PW: Right.
EB: But the fund is not trading for free. And most people, when we educate people, it’s like, “Oh, I didn’t know that was in addition to the management fee.” So if all that trading’s going on, it’s coming out of your pocket.
PW: I’m glad you made that point.
EB: Coming out of the fund company’s pocket.
PW: Yeah, I’m glad you made that point because, yeah, that isn’t necessarily clear to people that there is an expense and you are paying that expense, and then you’re still missing out on exposure in areas of the market that are really, really important. It’s a product-related way of doing things, and product-related ways of doing things are typically not a great way of approaching fixing your financial problems.
Target Date Funds
PW: But anyway, I just thought that was interesting, something we’ve been talking about for quite a while because people ask. And I’ve heard financial people that try to dismiss what we teach here, saying, “They’re just indexers. That’s all they’re doing. They’re just an index fund, blah, blah, blah, blah.”
No, it’s a little bit more sophisticated than that. But the indexing idea is valid, and a lot of times we will use it in a 401(k) because we don’t typically have necessarily the choices we want. And it is a better alternative.
You just miss a lot of asset categories with it because a lot of areas of the market aren’t indexed at all.
You don’t have funds that actually do it because there’s no demand for them. But also the issue is the way they’re managed. But it can be a real, real big problem if you’re looking at target date funds, as Evan was talking about, because a lot of the target date funds are using total market index funds, and they are super, super overweighting this big area of the market.
And as much as I possibly can, it’s like when I first started this show back in the early 2000s, I made the point about a lot of things that you shouldn’t be doing. I couldn’t get people to actually change and not do them until after they had lost all this money.
It was like with the 2001 and 2002 market downturns. Then all of a sudden, “Oh yeah, maybe we ought to listen to this.” No, listen to it before it happens. Thank you.
EB: Right.
PW: And the other thing that’s interesting is that they talk about in here, there was an article that was talking about where money is flowing, and since it’s so related to this, let’s talk about that next because investors are doing something really, really crazy as far as what they’re doing in the stock market right now based on the news. And I want you to be aware of it because this is something you have to make sure that you shore up.
Don’t do this garbage. This is bad stuff. And I’ll get to that right after this.
Scrapping 401(k)s
PW: We’re going to talk a little bit about what’s going on in the world of markets and what’s happening, but not from a perspective that we’re going to go and predict the future because that’s a fool’s game, quite frankly — trying to predict the future.
EB: Totally.
PW: But that is what the industry is typically all wrapped up in. That’s what they’re selling. But they’ll tell you that’s normal, you can’t do that.
But then you watch them. Don’t listen to people, watch them. Watch them.
For example, there are firms, you go out there and look at their ADVs and you’ll see that they got like 14, 15, 16, sometimes even more asset management companies, and they all do something a little different. Well, how many different asset management companies do you need if you know what’s going to happen in the future? You don’t need that many.
How many different mutual funds? You don’t need 1,400 mutual funds. And some of these fund companies, the big ones that you see advertised all over the place, or that you probably have in your 401(k) at work, I’m guessing probably do because they’re huge comparatively.
As a matter of fact, there was a guy that was actually going, “We ought to just scrap all 401(k)s, all these people.” And he has a couple of points in just that. Did you see that?
EB: No.
PW: Yeah. He was just basically saying, “We ought to scrap all 401(k)s.” No, we shouldn’t scrap all 401(k)s, we should just make sure that the fun companies aren’t doing the stupid things that they’re doing with them.
It’s just like, “We ought to scrap all cars because people drive them too fast.” Well, some people do, but they’re a good vehicle.
EB: I might fall into that group, so I got to be careful.
PW: Well, the idea is the misuse. It’s not necessarily that a motor vehicle is a problem, it’s the misuse of it, which is dangerous.
I like that metaphor. I’ll keep that one. I don’t know, it just came out of my head.
Overweighting Growth Index Funds
PW: But anyway, investors have never — speaking of dumb things that people are doing — they’ve never withdrawn from S&P 500 funds like they did last week. This is what MarketWatch said, “Investors withdrew from S&P 500 ETFs, exchange-traded funds, by the largest amount on record, according to Lipper.”
Now, Lipper does a lot of investment industry research. S&P 500 Index Fund saw the largest outflows, according to data from Lipper’s Global Fund Flows.
In the week ending June 12, S&P 500 exchange-traded funds saw outflows of $17 billion even as the index advanced by 1.25%. But I got to pull out before it goes up. It seems like investors were backing growth funds. Oh, isn’t that great?
So S&P 500, roughly the 500 biggest companies in the US, okay? So when you’re looking at the 500 biggest companies, as we just mentioned, it’s just hugely overweighted with some big growth companies, as we talked about.
Six companies make up like a third of it. That’s just crazy sauce. There’s just a lot of money in just a few big companies, which is dangerous. Well, are they becoming prudent and pulling out because they don’t like that concentration?
No, they’re becoming even more concentrated. They’re buying S&P 500 exchange-traded growth indexes, the growth ETF, IVWs, where they’re putting their money.
Well, why would they be doing that, Evan? What would be the reason to go and take your money out of the S&P 500 and put it in the growth? Can you think of any?
EB: I’ll take performance-chasing for 500, Alex.
PW: I’ll change my name to Alex, but no. Yes, that’s it. That’s exactly what they’re doing.
EB: They’re overweighting the six stocks that were beating the other 494, piling all in while they’re doing a peak. We don’t know it’s a peak; I shouldn’t say that. While they’re at a new high.
PW: Yeah, at a new high.
EB: They’re adding more.
PW: Yeah. And this is exactly what’s going on. S&P year-to-day performance was about 14%, but the S&P Growth Index, which they’re piling into, was 24%, almost 25%.
So literally, they’re going, “Wait a minute, 25% is better than 14%. I think that’s where I want my money. I want my money in something that has a higher return.”
Well, that’s past performance. You can’t look at that and go, “That’s going to be continuing into the future.”
Misusing Investing
PW: Then there’s some people that are just plain market timing because they yanked it out of MoneyMarket, right? Yanked it out of stock funds and put it in MoneyMarket funds.
EB: And I think it’s significant in that story that they’re addressing ETFs and not funds.
PW: Oh, good point. Really good point, yes.
EB: Because in theory, if you decide you’re in a 401(k) and index funds are the only choice you have, and okay, you’ve got to play the can you’re dealt, ETFs, exchange-traded funds, that are mimicking the index, which should be a buy-and-hold strategy, they can trade these things more frequently and likely do. They’re misusing why they invested in an index in the first place.
PW: Right. The whole idea behind the index fund is stock picking and market timing are foolish, don’t do it. You can get lucky and beat the market, but you’ve got to attribute that to luck.
Then what they’re doing is engaging in literally what the fund or the ETF was designed to avoid.
So they’re literally just falling back into the same trap without even recognizing it. John Bogle actually hated the idea of the ETF for that very reason, interestingly. He was the founder of the company, Vanguard, that actually is one of the biggest traders of that stuff these days, and he hated the whole idea of it, and now they’re the biggest.
So it goes to show how the industry just typically does not stay terribly disciplined, and they’re not great at keeping people disciplined. It’s like, are you going to change a problem? Are you going to get rid of a problem that you profit from keeping people in is really what it gets down to?
The answer is usually, “No.” That’s unfortunately the case.
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.
