HWeekend Reading – More warnings against index funds
Hi Folks!
Welcome to some new Weekend Reading: an interesting one about more warnings against index funds.
(I also want to thank more readers once again for their questions! I enjoy them. I put a few recent ones in this Weekend Reading edition.)
In case you missed some recent posts and other Weekend Reading:
This was a popular free case study: a 60-something couple that feels ready to retire. So, how long can they spend $1 million from their RRSP?
And…in my last Weekend Reading edition, I shared debt remains crippling for many Canadians – so I shared some thoughts about how I got out of debt myself.
Weekend Reading – More warnings against index funds
This article caught my eye this week from The Globe and Mail (subscription) with the subtitle: Have passive investors gone too far?
The Globe referenced this paper entitled Passive Aggressive: The Risks of Passive Investing Dominance.
The paper highlights a bit of what we are experiencing now: new money inflows into passive products overweight overvalued stocks and underweight undervalued stocks due to the market-cap weighting nature of these funds. As a result, many passive products can create distortions. Money is simply flowing-in without any stock fundamentals at all – i.e., there is a higher chance over time of creating a bubble due to misvaluation.
One solution to this problem of course is not using a cap-weighted fund or ETF but instead an equal weight or smart-beta fund product. Something I wrote about almost 10 years ago.
What do I think?
As the Globe article suggests…I also believe “Market history is full of good ideas that were taken too far and caused big problems for investors.”
While I certainly believe in the spirit and merits of diversification, I also know that indexing has flaws. First up, you get all the “good stocks” and “bad stocks” as a package. Just the way it goes. There are other problems too. Indexing fan and guru Larry Swedroe even believes so.
Problem #1 Erosion of Diversification
“As passive funds grow, stocks within major indices increasingly move together, undermining the diversification that index investing was designed to provide. This rising correlation means that sector and business-model differences matter less for portfolio risk, exposing investors to larger market swings.”
Problem #2 Structural Divergence in Market Responsiveness
“Stocks with high passive ownership are exhibiting higher betas—greater sensitivity to market movements—while those with more active ownership are showing declining betas. This divergence points to a market increasingly driven by coordinated flows rather than fundamental price discovery.”
Same arguments as the recent paper cited above.
I’ve been on record for 15 years here to highlight that indexing is a great thing for the majority of DIY investors – and I still believe that. I’ve written hundreds of times, when in doubt, index invest.
I do the same! I eat my own cooking. 🙂
But I’ve also been equally on record to suggest that my “hybrid approach” to investing works well for me/us too since I can’t say whether or not longer-term index products unto themselves are not going to cause some market disruption they sought to simplify the investing universe in the first place.
So, as a result, I own income and growth stocks: a basket of 25-30 stocks at this time that rewards me as a shareholder via rising dividends so I earn growing income over time.
I wouldn’t be where I am, semi-retired, far sooner than most, without my hybrid investing approach.
I like stocks for income and growth and I really like indexed funds for long-term passive returns.
I don’t to intend to fix what isn’t broken.
The rise and dominance of passive investing has been excellent for many DIY investors – I have benefitted as well!
Index investing has delivered low-costs for DIY investors (leaving expensive wealth managers in the dust) along with delivering global equity-market diversification options that no DIY investor could possibly build and sustain on their own.
Even as big as an advocate as Swedroe has been on indexing over the years – he seems a bit concerned:
“Investors should be aware of these evolving risks and consider systematic, factor-based strategies as a way to capture the benefits of passive investing while mitigating its growing structural weaknesses.”
Food for DIY investing thought!
Other Weekend Reading – Beyond more warnings against index funds
Related to this article above, passive investing might have broken the markets from Morningstar.
In a recently updated post, I wanted to highlight I sold ALL QQQ ETF from our portfolio recently for a key reason you can read about above – portfolio simplification and more diversification.
Fun stuff from the Twitterverse/X world. I think about this often too! @DividendGrowthInvestor
Reference: https://x.com/DividendGrowth/status/1961412267943014757
Worth the watch from The Wealthy Barber Podcast – thanks to a passionate reader for sharing.
The highlights and what I will consider writing more about over time related to taxation and estate planning for us:
- Max out your registered accounts (i.e., RRSP, TFSA, etc.) first as much as possible as you accumulate assets towards retirement. Yes, you should max out your registered accounts, first.
- For younger Canadians (20-somethings) open up your FHSA (First Home Savings Account) and contribute to it often.
- Large tax refunds are not a good thing. I’ve shared that many times here too.
- Have a Will.
- Start taking out your RRSP/RRIF assets in your lowest-income years in retirement, ideally before both CPP and OAS come online. I’ve written about that many times…
- Our tax system is not kind to individuals vs. couples. Not surprisingly.
- Avoid being an Executor, unless there is a simple estate. Always consider a back-up Executor or a Corporate Executor. For example: CIBC Trust can handle the complex, time-consuming duties of estate administration, including asset management, tax filing, and managing beneficiary relationships, providing peace of mind to the estate creator and ensuring the will’s provisions are carried out fairly. Something to consider!!
- If you have wealth, gift the money while you are alive!!
Reader Questions of the Week (adapted slightly for the site)
Mark, are you still 90% stocks and 10% cash/cash equivalents? I think I read that somewhere…
You are correct!
My plan is to spend some of the 10% (cash/cash equivalents) in 2026 or 2027 in our early retirement years, allowing our 90% equities to grow a bit more. Maybe that’s too much cash?? I dunno. Sleep-at-night factors are important.
Mark, I read your post about selling QQQ this week. Are you selling anything else we should know about?
Not at the moment.
My adjustments over the last year or so are largely tweaks in preparation for any retirement in 2026 – like I mentioned in that QQQ post – with a focus on raising cash/cash equivalents for all 2026 spending and where possible, all 2027 spending too. This way, I don’t have to touch our portfolio at all for the coming two (2) years! During 2026 and 2027, I/we can spend that cash/cash equivalents. We will let our existing equities (90% rest of the portfolio) churn out more dividends and distributions for future spending in 2028+.
I can break down what I’ve branded as my Retirement Income Map in future posts.
I always welcome your thoughts on my cash wedge approach.
Have a GREAT long weekend!
Mark
Hi Mark,
I’m an ETF investor and I don’t really plan on changing anything for now.
I’m also about 3 years from retirement and I wanted to slowly let the dividends from my ETFs, however small, build up in cash equivalent until then. Like you a have the following accounts: LIRA, RRSP, TFSA and taxable, and I was wondering on which account(s) do you suggest I should turn off DRIP first? My initial thought was to first withdraw from RRIF and LIF, and use the taxable only for special expenditures, while keeping the TFSA untouched until later.
Congrats, Paddy – so close to retirement!
I have done the following to date:
https://www.myownadvisor.ca/faqs/
See that page for DRIP details.
1. I have turned off all DRIPs in our non-reg. accounts. Cashflow coming in via dividends and distributions to spend the money in retirement. Likely starting in 2026.
2. I have tunred off all DRIPs in our RRSPs. I will need that cash for withdrawals in the coming years. Again, likely some small withdrawals in 2026.
3. I have one small LIRA, I keep DRIPs turned ON for that one – I have a few years for it to compound before I access it. I will be turning my LIRA into a LIF in a few more years.
4. DRIPs are always ON inside our TFSAs. I won’t be touching TFSA assets for a few years from now. re: keep untouched until later and DRIPs always on since there are no adjusted cost base issues to deal with either. 🙂
Let me know your thoughts!
Cheers,
Mark
Makes sense to me too Mark. I might stop dripping the LIRA sooner than you though since it’ll be one of the first account I’ll withdraw from. Thanks for helping me think this through!
All good, just what I am doing – good, bad or indifferent. 🙂
I will post my results on the site.
Cheers!
For now, and likely forever, I’ll be sticking with index funds, as I believe the pros outweigh the cons. My timeline is much shorter than that of a 20-year-old, so I suspect any very long-term issues probably isn’t something I need to worry about.
Regarding the cash bucket/wedge: despite potentially missing out on large equity gains, I just can’t bring myself to reduce our cash/fixed income reserve to only one or even two years. Instead, I’ve increased our dividend income by switching 35% of our portfolio to index ETFs (XEI, ZDY, and ZDI), which I expect will allow me to comfortably reduce the cash requirement accordingly. I do envy, at least to some extent, those who can live on the edge, but I’d be in big trouble with my wife if I got it wrong!
It’s hard to argue with the success….I think XEI (Canada), ZDY and ZDI beyond Canada of course are excellent.
I/we own thousands of units of XAW for diversification reasons.
Ya, we’ve been building our cash wedge/bucket for a few years.
Our plan is rightly or wrongly:
– spend from cash/cash wedge in 2026 (money already saved).
– spend from cash/cash wedge in 2027 (money saving is WIP).
Between 2026 and 2027, we plan to keep most DRIPs off and let cash build up again in the coming years so that for 2028 spending, cash is there yet again. So, we might not need to sell any equities until 2028 sometime.
I can’t live on the edge, either Bob = just not wired that way.
Thoughts on my plan? Not touching the capital for a couple of years just in case things slide??
Mark
Hi Mark,
I think your plan is excellent if the dividends are building up enough to cover your needs + maybe some part-time income. Now might be a good time to stress-test your portfolio with a simulated 2000 dot-com bubble or 2008 housing crash and see how it holds up. It’s not so much about will your portfolio last 40 years into the future, but can you still have the lifestyle you want during the next five to six or so years, without having to significantly cut your spending.
Who knows what’s coming at us, an AI bubble, the end of USMCA, US civil war II, or even a US invasion of Canada (since you can’t hold an election when you’re at war). Seriously, and none of those scenarios are entirely impossible anymore, we don’t know what it will be, but we can be pretty certain something big is going to happen one day!
Bob
Thanks very much.
I think it’s a good plan but I won’t really, really know until I use it! 🙂
We are getting to the point whereby once my wife’s LIRA is invested, not in these updates at all (see below), in a few more months, the thinking is all portfolio income will be > expenses. I’ll share more when the time comes.
https://www.myownadvisor.ca/august-2025-dividend-income-update/
Right now, even if the portfolio earns 5% per year on average then portfolio returns are > expenses. If we don’t spend more from it, it will continue to grow…
We have our spending set almost for almost the next two years in cash/cash equivalents without touching the portfolio at all.
More work to do still but almost there.
That means until 2028 or so, I wouldn’t need to sell anything unless I wanted too – but of course I will over time.
So, starting in 2028, we will start selling our capital bit by bit and live our lives…
I would agree the “dangerzone” for us or any retiree is the first 5 years or so due to poor sequence of returns risks.
I figure having cash or related assets to spend in 2026 and 2027 is smart.
I figure having our portfolio by 2028 deliver income > expenses on yield alone will be a good hedge for that.
I will be too young to accept CPP, OAS or my workplace pension.
I welcome your thoughts!
Mark
“ The paper highlights a bit of what we are experiencing now: new money inflows into passive products overweight overvalued stocks and underweight undervalued stocks due to the market-cap weighting nature of these funds.”
This sentence is problematic. Buying passive does overweight overvalued stocks but so does any strategy involving buying lots of stocks. Market cap weighting has nothing to do with it.
The problem is that real value is defined by future returns. Without a crystal ball we don’t know what they are. The fact a company A has larger market cap than B does not mean that returns of B will be higher. Buying equal weighted index won’t help you at all; you are just taking a wild and random bet on smaller companies.
There is no empirical evidence that analyzing fundamentals can help reduce “overweighing overvalued stocks”. Factor investing is interesting but the “advantage” of each factor tends to diminish rapidly the moment a paper on a new magic factor is published. This can be argued but blaming market-cap weighting for buying “overvalued stocks” suggests lack of understanding. Unfortunately I can’t read the full paper you linked so not sure if they really said this.
Fair comments, including factor investing.
Maybe worth a read:
https://www.morningstar.com/funds/what-happens-if-everyone-indexes-2
Or from Bogle himself:
https://finance.yahoo.com/news/jack-bogle-envisions-chaos-catastrophe-markets-everyone-indexed-194610197.html
I’ve mentioned on this site, many times, that we’re not at a tipping point for indexing whatsoever but we are getting closer.
I continue to believe index investing is a very good investment strategy but it’s not perfect. That’s all. 🙂
Mark
Thats true. Nothing is perfect. And like you say, Index Investing outweighs overvalued companies. You buy lots of duds. The problem is that the perfect investor who does not would be putting all his money into a single stock which will grow the most, and hence is the most undervalued. Its a problem because we have zero idea which one it is.
The issue with some of the above claims is suggesting that buying equal weighted index would somehow make this problem go away. Its not as good as market cap for a number of reasons. And “dividend investing” is a bad proxy for value investing (obviously my opinion).
I appreciate your comments. I simply see some challenges with indexing products and some factor-based investing could help with that.
That said, indexing remains one very important way for many retail/DIY investors to invest. I truly believe that. I just don’t have my entire portfolio in indexed products but one can be very successful that way of course. Behaviour trumps all.
Mark
Its not binary. There is quite a bit in between pure stock picking and getting a single cap-weighted index fund for the world. To me factor investing is a variation on indexing because factor ETFs use indexes. I use a bit of that too. I just try to stay passive, so that no human decision making is involved at my end except for original plan.
Indexing, passive investing exists on a continuum for me. There are extreme forms, removing as much “human” intervention as possible (which is not for me) and there is a quite a bit of active management. The indexes are in constant motion. See TSX today. 🙂
I’m just a fan of a bit more active management in my portfolio. Plain and simple. So are many DIY investors. Some to their benefit and some to their own detriment. I can only speak for my financial goals. I’ve realized them probably sooner than most. That’s not a competititive statement, rather, financial indepdendence earlier in life was always more important to me/us.
Cheers my friend!
Mark
Don’t think the article and some of the assessments are far of the mark Cap weighted indexes can be a problem. Imo the issues are solely with the SP500 and Nasdaq. They have returned well historically but unfortunately some of that is simply price inflation not value add. Demand>>> Supply (SP500/Nasdaq iShares ETF’s trade on at least 23 global exchanges excl.US/Can to the tune of 100s $B. Add Vanguard/SPDR/Schwab and local providers and the amounts are staggering all targeting the same limited recourse effectively buying the same 100 large caps. A good portion will be passive (auto deposit+buy/DRIP/401K’s/Robo stuff) so prices go up regardless if that actually makes sense or not. So yes it’s a self fulfilling prophecy/feedback loop.
Problem is what is the alternative that would work at scale?
Not sure there is a solution to this long-term other than much more price discovery if “everyone indexed” per se. That could make some active management / active investing much more rewarding but not sure we are at that tipping point yet – but we seem to be approaching it.
Mark
I really enjoyed the Golombek podcast. Lots of stuff I agreed with but I’d opine that sometimes taking on an executor role might be an obligation issue. Sometimes we have a duty to step up even if we’d rather not. Finding out very quickly that the tax system is not a positive force for a single. But it is what it is.
I’m not going to get my stuff in a knot over that downside of ETFs. They do the job I need them to do in the situation I have them in so I’ll continue to use them as required. Might cost me more in fees, but it’s worth it to me for their simplicity. YMMV
I agree with the Executor role and your comment. Sometimes, it’s just necessary.
I also think low-cost, broad-market ETFs are some of the best decisions most DIY investors can make.
Best wishes back,
Mark
My take on index funds is pretty simple, time and time again if I compare a mutual fund or managed ETF performance against the associated index after fees, the index always wins. This happens because the management fee is pretty minimal, the index is managed by an external source, changes are rare so it’s just a matter of handling adjustments once in a while and doing ETF paperwork (audits, etc). Now somebody like Warren Buffett can beat the S&P500 over time but he is a rare investor and even he falters occasionally while the S&P500 chugs ahead. So until a new approach to investing (that isn’t dependent on one person/company) approaches the performance of passive index investing after fees, writers can discuss it all they want, results are all that matter to me.
Can’t seem to edit my comment. To comment on the alternative index funds, if these equal weight index funds have better performance than the standard index funds, they would be a good alternative. I doubt they will but data proving I’m wrong is welcome and I will change my investment direction with new data.
Smart-beta and other funds seem to be an excellent alternative but those do come with higher fees too = more activity.
At the end of the day, indexing as an investment approach is still a very, very good way to invest. I do it myself for part of our portfolio and likely always will.
Mark
Index funds are problematic to a point but hard to argue with what you are saying in terms of returns less small fees.
I’m certainly not Warren Buffett!