Is Buying a Free S&P 500 Index Fund A Wise Decision?

by Vince Birley

Introduction

With trillions of dollars flowing into now free passive non-managed funds, is it wise to join this trend? Some pundits are claiming that this new form of investing is creating a new investment bubble getting ready to burst. Others are saying it is the new way to invest. This paper explores both claims to help Christians navigate this decision.

What is an Index Fund?

An index fund is a fund that tracks an index. A market index is used to measure publicly traded securities markets. It is a tool used by investors and financial managers to measure segments of the market and to compare returns.  

The first market index was created by Charles Dow in 1896 by averaging the stock prices of the top 12 publicly traded companies; Dow went on to create other indexes. The most popular index now is the S&P 500 Index.  

The S&P 500 Index is a market capitalization weighted index (commonly called a “market cap index”). To calculate the market cap of a company, one must take the number of outstanding shares and multiply it by the current share price. The S&P 500 Index compiles the largest 500 U.S. companies and weights the companies according to each company’s market cap. For a simple example, assume the total market cap is $100 for three companies valued at $70, $20, and $10. The $70 company gets a 70% weighting, the $20 company gets 20% and the $10 gets 10% of the index.  

An index fund mirrors an index by buying the same securities at the same allocation as the index. The first index fund was started on December 31, 1975 and was sponsored by Vanguard and called the First Index Investment Trust. It tracked the S&P 500 Index and was later retitled to the Vanguard 500 Index Fund. Today there are $3.4 trillion in assets that track the S&P 500.

Are Index Funds Creating the Next Stock Market Bubble?

There are current arguments positing that index investing is creating the next stock market bubble. The theory is that money is flowing into index funds buying stocks of the index without any fundamental analysis. This blindly increases the stock market to valuation levels that are greater than the inherent value of the companies.  

This idea makes sense when the amount of trading activity reaches a point where there are not enough market participants to exploit price distortions in the market. Without more discerning market participants, prices become irrationally high. This creates a price bubble that one day the markets realize and the bubble bursts, e.g. tulip bulbs in the 17th century, tech stocks in the late 1990s, and collateralized mortgages in the 2008-09 financial crisis.  

Some of the statistics that support these concerns are the number of funds tracking indexes. In 2019, the number of index funds rose to 45% of all fund assets from 25% just ten years earlier. Other reports from J.P. Morgan suggest the number of funds tracking indexes and using quantitative strategies (computer driven) have reached 80% of all fund assets. Even though funds are increasingly tracking indexes or are computer driven, index funds only own around 14% of all outstanding shares. And to minimize further the impact of index funds, these funds represent only 5% of the daily stock market trading.  

While the rise of index investing is considerable, there appears to be enough non-index market participants to have efficient price setting of stocks. It is worth watching these levels as at some point indexing could reach what the industry is calling “peak index.” Peak index is when active market participants cannot exploit mispriced securities and the market becomes inefficient, creating irrational pricing.  

Is It Wise to Invest in an Index Fund?

Over the last ten years I have worked on creating investment solutions based on a biblical worldview to help investors more wisely invest in the public securities markets. In summary, our research revealed that public markets reflect both human behavior and the collective power of human innovation and productivity. The public trading and price setting of public securities reveals the herding effect of investors that swings from overly optimistic to overly pessimistic outlooks. Markets over the long term also reflect the ability of people to create more wealth than they consume. Their profits reward and attract additional capital. Economies and markets are both uncertain and unstable. It is uncertain as to which industries, companies, or innovations will attract the most capital. Instability is something we should expect as well with economic recessions and market corrections. The coronavirus is a current example of the instability of living in a fallen world and the market’s perspective on the future.  

The research indicates that investors should evaluate public market options with clear goals for returns over their identified time frames. Most of the industry is focused on relative return goals, beating their peers and market indexes. One of the reasons there is so much money being allocated to index funds from professionally managed funds is that most managers fail to beat an index. Given this difficulty, investors desiring to beat indexes are pushed toward buying index funds, giving up on their more expensive professional managed funds.  

Most people invest to get a return on their savings to one day use that money. Therefore, an investment process must factor in risk management elements to better protect their savings. The first risk with investing in public stocks is that the short-term price volatility makes investing in stocks uncertain. Again, as I’m writing this paper, the S&P 500 is down over 10% in just six days. This makes a S&P 500 index fund imprudent for short term savings. Research suggests public stocks need at least ten years to provide investors a reasonable positive return on investment. 

Using a ten-year time frame, the following factors give an investor the highest probability of a positive return:

Quality – Improve the quality of companies by choosing better managed companies with good track records and honest accounting.

Price – Avoid stocks that have unrealistic expectations for future growth.  

Diversification – Make sure there is a highly disciplined diversification strategy that invests in an appropriate number of different companies.

Discipline – Systematically sell higher priced stocks and buy lower priced stocks.

These practices yield insight on using index funds, specifically the S&P 500:

Quality – The cap weighted index does not analyze any quality factors of management or their historic track records. The only factor it uses is the size of the company.

Price – The cap approach buys more of the most expensive stocks. The current top five holdings in the S&P 500 Index has an average price to earnings ratio of slightly over 30 as of 2/26/20. This means that investors are paying 30 times the earnings of a company. Forecasting these earnings to achieve a 12% return requires earnings to grow 21% per year for the next ten years to justify this price. To give some historical perspective, the historical average price-to-earnings ratio is 16 and the historical average earnings growth of stocks is 7%. To put this another way, in order to get a 12% return on your investment over the next ten years requires a company to grow their earnings by 21% per year which is three times the historical growth rate. While this is possible, it is not prudent for investors who need their money with a reasonable return one day.  

Diversification – Today the top five holdings represent over 18% of the S&P 500 Index while the bottom 300 stocks represent around 18% of the same index. Cap weighting significantly concentrates the holdings into the largest holdings giving a very small exposure to smaller companies.  

Discipline – One of the tenets of successful investing is to buy low and sell high. The cap weighting method buys more of what became more expensive and sells more of what got cheaper. In other words, it is a buy high and sell low strategy. This can work in the short term due to the herding tendencies of buying by popularity. This explains the recent success of the S&P 500 returns. However, over longer periods of time the buy low/sell high strategy delivers a more consistent return.

Our research concluded that buying index funds are the most efficient tools for tracking markets, but markets do not adequately mitigate risks that increase the probability of investors getting minimum returns over longer periods of time.     

Our Solution

Our firm sought to develop indexes that reflect the risk management factors for investors prioritizing their long-term goals. Over the long-term, this approach provides a higher probability of success.  

Our indexes include quality and value factors including the board’s level of engagement in oversight of the leadership’s compensation plan, the quality of financial statements, and the historic profitability and earnings growth of a company.  

Our indexes also mitigate the risk of speculating on price by finding better-valued companies that have realistic projected growth rates. And last, to mitigate the risks of too much concentration, our index put a maximum allocation of 0.5% per company.

Conclusion

Following the world’s decisions typically does not reflect biblical wisdom. Investing money into a fund because it is popular and free doesn’t necessarily make it wise. This is not to say that investing in these funds are dangerous; Christians should analyze their investment decisions through a biblical worldview that clarifies their goals, analyzes and mitigates risks in meeting their goals, and takes advantage of the opportunities. Ultimately, Christians should find contentment and peace in their prayerful decisions, trusting God with the results.