The Problem with Herding into Index Funds

There has been a lot of media coverage recently on the virtue of investing in index funds. Headlines such as “Index Funds Rule” permeate the financial media. Warren Buffett’s annual shareholder’s letter again recommended “both large and small investors should stick with low-cost index funds.” Buffett’s advice is not new; he has been saying it for years. But now everyone else is saying it. You get the feeling that you’re an idiot if you don’t put all your money in index funds. It’s a similar feeling we got with technology in 1999 and real estate in 2006. It’s the feeling that comes from herding.

Show Me the Money

Now if it was just media coverage, it wouldn’t be herding, it would just be noise – which the media is very good at. The herding comes from the actual flow of money. The Wall Street Journal recently reported that over $124 billion has been invested in ETF’s since the start of the year. ETF’s are common vehicles for index investing. Money has been pouring out of active management and into passive (index) for many months now. The active management community is responding by lowering fees to become more competitive.

I like index funds. I am all about low cost investing. I believe they have a place in a portfolio. I also believe active management has a place in an investor’s portfolio. With both index funds and active managed funds, some are better than others. My real issue is that when it comes to herding, whether it be into index funds or some sector, people aren’t thinking critically about their decision.
Consequences of Herding

Herding feels good. It feels right. There is safety in numbers – or so we believe. Prior herding scenarios such as the tech bubble and real estate show how high something can go, and how quickly it can fall apart. But what about herding into a style of management such as passive rather than something more specific such as a sector?

From a purely behavioral standpoint, one could say that index funds are near the end of their run because everyone is interested in them. It is the “no brainer” investment. In the past, this type of behavior has signaled a top and subsequent downfall. But in order for a market index fund to do poorly, the entire market would have to turn over – which is possible. In that case, active management, which has the ability to manage risk by raising cash and overweighting more defensive securities, may benefit. Is now the time that active management outperforms passive? Who knows. We will find out in a few years. If so, it may show that herding is a reliable contrary indicator not only within investment themes/sectors but also the style of management.

The Real Problem with Herding

This really doesn’t have anything to do with index funds. Studies show that whether investors invest passively or actively does not influence their performance as much as the buy/sell decisions they make. All this talk about active vs. passive outperformance has to do with investment return. The real issue at hand is investor return. We don’t care how much an investment makes; we care how much we make.

The real problem is that herding behavior influences us to do something just because everyone else is doing it. Let me guess – you like the low cost of index funds. I do too. But if you like low cost so much, why didn’t you do this years ago? Just because something feels right and is a “no brainer” doesn’t mean it is right for you. Be sure to think critically about your choices.

Just about every investment has pros and cons. A significant pro to index funds is the low cost. But before you jump, be sure you also understand the cons. While index funds receive all the upside of the market, they also participate in all the downside. And if we have learned anything about financial markets, it is that the downside will come.

Herder Beware!