Weighted Index Funds Vulnerable to Bubbles

Letter to the Editor in today’s Wall Street Journal:

John C. Bogle and Burton G. Malkiel (“Turn on a Paradigm?” editorial page, June 27) accept that market-weighted indexes over-weight stocks that are overvalued and under-weight stocks that are undervalued, but dismiss the point altogether by referring to the weakness as temporary.
It is anything but temporary. The bubble that carried Japan to 42% of the world stock market in 1988, making it a third larger than that of the U.S., spanned eight years. Japan is now at 12%. The tech bubble that carried that sector to 28% of the world stock market in 2000 lasted four years. It is now at 8%. Are we in an extended oil and gas bubble now?
When such speculative bubbles occur, the $3 trillion of capital invested in market-weighted index funds will be misallocated, along with the additional assets invested in enhanced trackers.
Institutions have, not unreasonably, come to rely on market-weighted index funds as a high capacity investment strategy for their core assets. This reliance renders them defenseless in extended periods of capital misallocation, which repeatedly afflict free markets. This reality is ignored by Messrs. Bogle and Malkiel.
Only those investors in market-weighted index funds with stable cash flows can hold the index until the bubble subsides. For most however, this is not possible. Given that speculation is essential to the proper functioning of a free market, because it provides the liquidity demanded by long term investors, those who rely on market-weighted index funds for their core strategy will always be vulnerable to bubbles.
Their only defense is to increase diversification of their core assets. They must branch out to add new strategies that are not dependent on the market-weighted index. Fundamental indexing is currently the only high capacity investment strategy alternative out there that works. And for this reason it will not fade away.
David Morris
CEO
Global Wealth Allocation
London

He makes a good point. Index investing is far less “neutral” than investors have been led to believe. According to indexing, the fact that a stock outperforms the market will, by definition, give it a larger weighting. If anything, it ought to lead investors to the opposite conclusion.

Posted by on July 12th, 2006 at 10:31 am


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