Most investors realize that you’ll probably do better indexing your portfolio to the S & P 500 or the Dow Jones Industrial Average than by lurching around in a brokerage account. Brokers live off commissions on transactions.  This is not necessarily the best approach for the customer.  And many fund managers charge more than they should.  Then, the average mutual fund investor stays aboard for four to five years, but unfortunately tends to buy toward the top of a cycle and sell toward the bottom.  So investor performance is around half of fund performance.

The world owes a great debt to John Bogle of the Vanguard funds, who has spent decades popularizing these ideas.

However, while conventional indexing produces better results than most active management it may still not be the very best solution for everybody.  The Dow is a selection of excellent companies that changes from time to time.  In fact, you could call it a managed large cap portfolio.  This is a fine solution for long periods, but it does involve some buying and selling.  So the old trustee solution of a dozen major well-studied companies in several growing industries can be slightly more efficient.

Then, smaller companies are harder to analyze but usually do better than big companies, particularly in a rising market.  (The market does tend to rise irregularly, because a good company doesn’t distribute all of its profit as taxable dividends, but rather reinvests most of it to grow, taxable to the shareholder only at capital gains later upon sale. A good company sees opportunities in its industry that let it reinvest earnings at a higher rate, 20% – 30%, say, than its shareholders can achieve with their dividends.)

Should we therefore invest in a NASDAQ index fund?  No. The NASDAQ has a high concentration of technology companies and is capitalization-weighted; that is, each company’s weight in the index fluctuates according to its own market value. This can be lethal when the market develops into a bubble.

For example, during the enthusiasm for technology just three stocks (Microsoft, Cisco, and Dell) made up more than 50% of the weighting in the NASDAQ.  When they collapsed that index collapsed, and how!  From its high in 2000 until recently the NASDAQ was cut in half. (I love Warren Buffet’s comment back in those days that if he were running a business school, he would ask the students to analyze a dot-com stock of their choice.  Any answer at all would fail, said he:  They were all crazily inflated.)  So, it is often logical to put some money into an index of smaller stocks, but not necessarily a cap-weighted index.  An intelligently actively managed fund of small stocks is also a satisfactory solution.

Another kind of index fund is a package of commodities.  In recent years (though not in the last few months) these have done splendidly, for several reasons:

  1. The Chinese and other recently prosperous populations have been eating and building their heads off.
  2. The vogue for biofuels and the floods out west have inflated grain prices.
  3. The declining dollar means that any given commodity is being priced at a larger and larger number of dollars.  (However, the dollar has fallen below purchasing power parity in many other currencies, so the trend may be reversing.)
  4. All the foregoing has attracted huge speculative buying in commodities.

Thus, commodity indexing contributes to its own bubble.

Commodities are a speculation, not an investment.  An investment is a holding that based on reasonably predictable earnings will get you your money back.  A speculation is either an asset without that characteristic, or one whose future is unknowable, a gamble.  Most speculations or gambles lose money, so in general pushing investors into commodity speculation is just steering them into a casino.

A category of investment index that I like (despite recent declines) is emerging markets.  It’s best not to guess about countries, since the ones that go up the most are often the ones that at first glance are the most worrying. Better is to take a cross-section of excellent and attractively priced companies across the whole emerging world and see what’s on offer.  A recent careful calculation of 40 such companies, chosen while taking account of political and economic uncertainties, indicated a real growth rate in dollars of about 12%, and a price-earnings ratio of about 15.  Using the English conception of “earnings yield” – the percentage equivalent of the p/e – you are thus buying a 6 1/3 % return, rising at 12% per annum.   Not the wonderful deal it was some years ago, but better than most developed markets.1 It’s usually too much trouble to invest in Thailand or Nigeria, or whatever, and thus in this area an index fund is particularly appropriate.

So to sum up, indexing makes excellent sense in most situations, and is necessary in some.  And three cheers for John Bogle. ■