Roth: Retort To ‘Problems With Index Funds’

July 29, 2014

Nine answers to Larry Swedroe's nine problems with index funds.

Last month, Larry Swedroe wrote about the problems with index funds followed by more problems with index funds. In total, Swedroe noted nine problems. ETF.com asked me if I cared to take the opposing viewpoint, to which I quickly agreed, and the following is my counter to each of the nine points.

First, let me say I mostly agree with Swedroe's criticisms when it comes to narrower index funds such as those he used in his pieces. But I'm a believer in broad index funds and will use the largest index fund on the planet, the $347 billion Vanguard Total Stock Market Index Fund (VTSAX, VTI | A-100 and other share classes), to examine his points. Second, this isn't a piece debating whether factor investing is superior to market-cap investing (meaning, examining whether factor investing is receiving higher return as compensation for taking on higher risk).

Since I'm using a Vanguard fund to counter Swedroe's arguments, I interviewed Joel Dickson, global head of research and development in Vanguard's Investment Strategy Group. Below is my assessment of how Swedroe's nine problems relate to the total stock index fund and broad index funds in general.

  1. Sensitivity to risk factors over time. Swedroe argues that indexes that reconstitute annually lose exposure to asset classes or factors, using the DFA Small Cap Fund to show superiority (DFSTX). In actuality, the mutual fund VTSAX always has the market exposure of every domestic equity asset class and factors.
  2. Forced transactions result in higher trading costs. Dickson points out that VTSAX has a 4 percent annual turnover, minimizing trading costs. By comparison, DFSTX has a 10 percent annual turnover.
  3. Index funds risk exploitation through front-running. Front-running is certainly a cost to the investor but, again, Dickson points out less trading is the best way to protect the investor from front-running.
  4. Inclusions of all stocks in the index. Swedroe argues that penny stocks in bankruptcy and initial public offerings have very poor risk-adjusted returns. In actuality, Vanguard states that as of July 22, 2014, penny stocks represented about 0.01 percent of this index fund. Though it is true that IPOs have had lower returns in the past, we don't know the future.
  5. Index funds have limited ability to pursue tax-saving strategies. Swedroe asserts funds like DFA can offset capital gains with capital losses. Dickson says Vanguard "will take losses as long as it can minimize the tracking error from the index." He supports this claim, noting that the fund currently has a 0.89 percent tax loss carry-forward.

 

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