As indexing becomes the industry standard, fund companies are inventing complex new products to justify the high fees they once charged for active management.
The Paradox of Choice in Passive Investing
For years, the message to investors has been clear: avoid high-fee mutual funds and embrace low-cost index funds. This shift has been so successful that the financial industry has been forced to adapt. Because traditional index investing is inherently low-margin, fund companies have begun complicating the landscape to reclaim their profits. Today, an investor isn't just choosing an index; they are navigating a minefield of sector indexes, equal-weighted funds, and 'smart beta' products. What was once a simple strategy of buying the market has become a confusing exercise in product selection.
At its core, an index is simply a grouping of stocks designed to represent a specific segment of the market. Most traditional indexes are market-capitalization weighted, meaning the weight of each stock reflects its relative size. In an index like the S&P 500, a behemoth like Apple carries significantly more weight than a smaller company like Under Armour. While this is a sound starting point, the industry's proliferation of new index types often obscures the primary goal of indexing: broad, inexpensive diversification.
The Limitations of Large-Cap Bias
A common mistake among novice indexers is equating 'the market' with the S&P 500. While the S&P 500 is a cap-weighted index, it only tracks large-cap stocks, representing roughly 80% of the U.S. market's value. This leaves a significant gap. Historically, small and mid-cap stocks have provided higher returns than their larger counterparts. By ignoring these segments, investors may be missing out on the full engine of market growth.
A more robust alternative is a total market index, such as the CRSP 1-10. While the S&P 500 holds 500 stocks, the CRSP 1-10 covers over 3,500, capturing the vast majority of the U.S. market's value, including those smaller companies. These total market funds—available for U.S., Canadian, and international markets—form the ideal building blocks for a portfolio. They offer maximum diversification at the lowest possible cost, often with management expense ratios (MER) as low as 0.15%.
The High Cost of Thematic Speculation
To combat the race to the bottom in fees, fund companies have turned to sector-specific index funds. These products target 'hot' industries, such as marijuana or clean energy, that capture the public's imagination. However, these are often speculative vehicles rather than rational investments. For example, a marijuana life sciences ETF might carry an MER of 0.75%—five times the cost of a total market fund. There is rarely a fundamental reason to overweight a single sector other than a desire to gamble on a trend, yet fund companies continue to launch these products because they are highly profitable for the provider.
The Smart Beta Smoke Screen
Perhaps the most sophisticated marketing tool in the modern indexer's world is 'smart beta.' These funds attempt to improve on market returns by targeting specific 'factors'—characteristics like company size, relative price (value), momentum, or profitability. Decades of academic research, most notably by Nobel laureate Eugene Fama and Kenneth French, suggest that these factors do indeed explain a large portion of stock returns. In theory, tilting a portfolio toward these factors could lead to better outcomes.
The problem lies in execution. Many fund companies use the 'smart beta' label to charge premium prices for products that fail to actually capture the factors they promise. Analysis of multifactor ETFs often reveals that they do not deliver the expected factor exposure, making them a poor value compared to a simple total market fund. Furthermore, some providers build indexes based on 'factors' derived from data mining or flawed research. With over 600 supposed factors identified in various literatures, many are simply statistical noise used as a pretext for higher fees.
Prioritizing Simplicity Over Gimmicks
The evolution of the index fund has brought both opportunity and distraction. While there are reputable firms with long histories of successfully capturing well-researched factors, they are the exception rather than the rule. For the vast majority of investors, the most effective strategy remains the simplest one: a globally diversified portfolio of market-cap-weighted total market index funds.
The financial industry thrives on the idea that more complexity equals better results, but in the world of indexing, the opposite is usually true. Most specialized index products are little more than gimmicks designed to separate investors from their capital through higher fees. By sticking to broad, low-cost building blocks, investors can ignore the noise of the 'index revolution' and focus on the long-term growth of the global economy.