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The first three chapters of the book are targeted towards those who want to get a basic understanding of index funds. The first chapter talks about the massive growth of indexing and hence index funds & ETFs. The second chapter walks the reader through the history of various fund structures that came before index funds and ETFs. The third chapter gives a laundry list of entities that have benefited from the rise of index funds.

Chapters 4, 5 and 6 are different from the usual ETF marketing literature as they highlight the problems with index funds and ETF investing

Problems of Theory and Practice

The chapter highlights various problematic aspects of indexing

  • “In the long run, stocks always go up. Hence pick an index and stay invested”. The underlying assumption is that returns earned by business are ultimately translated in to returns earned by the stock market. This is the Efficient Market Hypothesis touted by academicians. However the market has always shown cyclical behavior and the average time that supposedly long term term investor stays in any fund in 3.5 years. Given these facts, the popular philosophy of “buy and index and forget it”, looks good on paper but ultimately fails to deliver
  • Risk = Reward Fallacy: The distribution of risk and fair returns is not a linear relationship. You might take on too much risk, not being aware of it, and pay for it in the long-term as markets slowly adjust price/risk anomalies, leaving you with years of unexpected under-performance.
  • Markets Always Rise Fallacy – This has been debunked in many markets across many time periods
  • Popular Indices are primarily Market Cap weighted, i.e. popular companies of the season make it to the index and make the index overpriced. Market cap-weighted indices will always over-represent the industries that cause a bubble in the first place. Index fund holders would always suffer the consequences of such market anomalies more than they actually deserved or even wanted.
  • Lot of Capital chasing passive industry might make market overvalued
  • Increased Margin Lending: To reduce operational costs, most funds are participants in the margin lending business, which in turn fuels short sellers activities
  • Companies outside of index face more difficult environments: In a world where market capitalization is the key factor of stock benchmarks today, companies with a larger market capitalization experience a disproportionate flow of trading activity in their shares, making it much easier for those companies to raise fresh capital at favorable conditions through stock issuance or bond finance. Keep in mind that this quirk goes back to the issues of market cap-weighted indices. Companies not included in a specific index don’t get buying attention from countless index funds. These companies have a much harder time raising capital from markets; it’s usually at less favorable financial terms, as there is less demand for bonds or stocks issued from those companies. The rich get richer.

Problem of Participation

The author highlights some of the key pain points associated with investor participation

  • Clients regularly underestimate the real fees involved even for index funds
  • Clients are confused by the product variety of today’s index fund universe
  • Clients have unreasonable return expectations induced by over optimistic advertising.

Another much touted wisdom is the application of asset allocation methodologies using index funds. This strategy has not delivered as expected. Target Date funds are a great example. Investors have realized that the so called “glide path” promised by the fund managers has been far from satisfactory. Most of the asset allocation strategies suggested by investment gurus is just a hogwash. The portfolio allocation – “Invest in ETFs in a specific proportion and forget it” hasn’t yielded good returns.

Problem of Narrative

The author talks about the various narratives that we hear about ETFs. He subsequently says that all those narratives never pan out. In reality, the following are the scenarios faced by index investors

  • Investors don’t achieve the buy-and-hold returns advertised by fund houses
  • Average holding period of a typical investor is 3.3 years
  • Index fund proponents often mention the intellectual superiority of index funds and those who buy them. They are supposedly more sophisticated and advanced than investors in funds with active management, just by association. Unfortunately, there is no evidence that buyers of index funds, especially ETFs, are more sophisticated than those buying traditional mutual funds or even simple stocks. Past statistics of inflows and outflows for index funds prove that the average index fund investor behaves the same as any other ordinary mutual fund investor.
  • Index investing is taking a massive bet on the market. Like any bet, it can go either ways
  • Buy and Hold doctrine narrative is hardly true if one analyzes the investor behavior of ETFs and Index Funds

The last chapter of the book tries to educate the reader on the way to go about index investing. I found this chapter very pretty cliched.

Trivia from the book

  • The big three index funds are Vanguard, Blackrock and StateStreet have 12 Trillion in AUM!
  • World’s first investment fund was floated in 1774 by a Adriaan van Ketwich
  • First index investment trust (Vanguard 500 Index Fund) was floated in 1976
  • 1924 saw the birth of first two open-end mutual funds
  • No one has profited more from the boom of index funds than the index originators themselves. It’s one of the best business models on the planet.
  • Bogle, the godfather of index investing, ironically made his money not out of index funds
  • According to SEC filings, MSCI boasts more than $1 billion in operating revenues for the year ending December 2015, operating income of over $400 million and net income of $220 million not so bad for a business that creates fictitious pools of securities in all imaginable sizes and forms. MSCI alone currently offers more than 160,000 indices.

I found nothing special about this book. May be the chapters that highlight the problems with index investing might be worth a quick read.

 

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