The popularity of index funds has absolutely exploded over the last 20 years, with investors collectively transferring a couple hundred billion dollars every year from actively managed to passively managed funds.
And the reason for this has been clear: index funds vastly outperform actively managed funds.
Although a minority have stood out as successful, most active funds are plagued by high fees, high turnover and taxes, and mediocre investing results to show for it.
According to the latest S&P Dow Jones Indices SPIVA research report, 92-95% of actively managed funds failed to beat their passive index benchmarks over a 15-year period.
Worse yet, there’s no reliable way to identify the small number of funds that will go on to outperform in the future; we can only look backwards and identify the ones that did.
The low cost, low turnover, automatic nature of index funds has been a crushingly superior investment compared to active management for decades, and this trend has been catching on more and more. Now, indexed ETFs have further expended the popularity and flexibility of index investing.
Vanguard, the world’s largest index fund company, now has over $5 trillion in assets, and Blackrock, the second largest provider of index funds and ETFs, has another $4 trillion in passively managed assets.
But there’s a huge difference between past performance and future performance, and index funds might be setting up investors for a generation of disappointing returns.
Why returns will likely be lower going forward
The S&P 500, the most common benchmark for index funds to follow, has given investors more than 9% annualized returns since its inception in 1928. But that rate of return has by no means been smooth.
If you invested in the late 90’s, for example, your investment would have been flat and choppy for the next 14 years until you finally broke to a new high point. A balanced allocation between stocks and bonds would have improved this somewhat, but returns still would have been less than great.
And this is a predictable result rather than random. Dr. Robert Shiller, an economics professor and Nobel laureate at Yale, two decades ago introduced the Cyclically-Adjusted Price-to-Earnings (CAPE) ratio, also known as the Shiller P/E ratio. It divides the current market price of the S&P 500 index by the inflation-adjusted earnings of those companies over the last ten years, and the result is a quite accurate representation of how overvalued or undervalued the market is compared to historical norms.
The higher the Shiller P/E is, the more investors are currently paying per dollar of earnings.
Here’s a chart of the Shiller P/E that I constructed using Shiller’s data:
The well-known fact is that the Shiller P/E at any given point is inversely correlated with investment returns over the next 10 and 20 year periods.
In other words, if the Shiller P/E is high, then your investment returns are likely to be choppy and sideways over the next decade or two, as these high valuations come back down to earth. High valuations result in lower dividend yields, lower growth from reinvested dividends, and lower EPS growth from corporate share repurchases, and less room for valuation increases during your holding period, resulting in mediocre or poor returns.
Robert Shiller has quantitatively tracked the forward 20-year returns of the S&P 500 compared to the Shiller P/E at any given point retroactively since the late 1800’s. The conclusion is that whenever the Shiller P/E was over 25, the rate of return over the next 20 years was negative. Here’s his data, from Irrational Exuberance:
More recent analyses using shorter ten-year periods has shown similar results; when the Shiller P/E of the market is over 25, the rate of return over the next ten years varies between about 8% at best or -4% at worst, which is a really crappy range.
At the risk of putting too much emphasis on just one valuation metric, another way to measure stock market valuation is a method popularized by Warren Buffett.
To do this, you simply divide the market capitalization of all stocks (the total price of all shares of all public companies) by the gross domestic product (the price of all goods and services produced in that year). If the ratio is higher than normal, it means share prices have outpaced actual production.
This ratio almost perfectly correlates with the Shiller P/E:
As the Shiller P/E of the S&P 500 currently stands at over 30, and the Capitalization/GDP ratio stands at over 140%, a century of data tells us that returns over the next 10-20 years are likely to be poor.
Stock market prices have vastly outpaced corporate earnings and national output, resulting in a highly-valued market, low dividend yields, and low buyback returns. The only historical periods where we had higher valuations than today were in the late 1920’s and the late 1999’s; both of which ended horribly for stocks.
McKinsey & Company largely agrees, and has a forecast for US and European stock returns below 6.5% per year, and US and European bond returns of below 2% per year, over the next 20 years. Their data are in line with what the Shiller P/E metric and the Buffet metric suggest will likely occur going forward.
John Bogle, inventor of the index fund and founder of Vanguard, agrees as well. In multiple interviews and in writing, he has outlined a simple rule of thumb:
Forward returns = dividend yield + earnings growth +/- changes in valuation
In other words, if the S&P 500 yields 2% right now, and earnings grow at 6% per year, and the high P/E deflates at a rate of 3% per year over the next decade, then your rate of return by investing in the S&P 500 over that period would be about 5%. This is directly in line with the high end of what 150 years of Shiller’s data suggests will most likely occur.
If you want additional proof, forget these broad valuation metrics and apply discounted cash flow analysis to a bunch of major companies you’re interested in buying. That’s the gold standard of valuation measurement on an individual-company basis.
You’ll see that for many companies out there, the fair value calculation you come up with is below the current market price unless you either a) assuming ridiculously high growth or b) use a very low discount rate, which means a low rate of return.
An example of how bad it can get
The S&P 500 has experienced relatively long stretches of flat returns, but Japan has shown an even worse outcome.
The Nikkei 225, the index of Japan’s largest companies, reached its peak in 1989 and never got back there since then:
That’s nearly three decades of negative returns. Even for investors that smartly avoided the bubble and invested years before or after it, their long-term returns were still in most cases flat and choppy.
The United States is unlikely to have a problem that severe, because the national population continues to grow while Japan’s population has been largely flat over the last 30 years. And Japan experienced an asset bubble twice as large as the dotcom bubble that occurred in the United States.
However, it’s a mistake to assume that the 9% annualized S&P 500 performance during America’s golden years, beginning after World War II as the world’s sole superpower and extending into the 21st century, during an unprecedented time of growth and innovation, will be repeated forever.
The United States now faces slower GDP growth, a higher public debt burden, an aging population, healthcare and education costs that are more expensive than anywhere else in the world, flat inflation-adjusted median household earnings over the past two decades, and a multi-trillion-dollar unfunded public pension bubble.
Even without those problems, the high market valuation alone indicates that forward returns are likely to be poor. Adding those things on top of it paints an even more stressful picture.
I’m not saying we won’t get growth over the next decade or so, but it’s likely that returns won’t be great.
Even if P/E multiples remain higher than normal for the long-term, it will keep dividend yields low, reinvested dividends less powerful, and share repurchases less effective, resulting in at best mid-single-digit returns. In almost any reasonable case, forward returns are likely to be lower than 9% per year.
Bonds won’t save us this time
A counterargument that some will make to this article is that a diversified portfolio that is continually re-balanced between stocks and bonds will take care of this, and improve our overall returns. And I do recommend holding bonds in a diversified portfolio.
Historically this approach has been helpful, with bonds providing stable returns over 6% during most years for decades, but the data also indicate that bonds will likely produce worse results going forward as well.
This is a chart by the St. Louis Federal Reserve of the federal funds rate over the last several decades:
Here’s the problem. Bond prices and interest moves are inversely correlated. As interest rates drop, it pushes up the value of existing bonds. This 35 year reduction in interest rates from a very high level has propped up bond returns for the past 35 years. And for the last decade, we’ve had an unusual stretch of abnormally low interest rates.
Only in the past few years, the Federal Reserve has gradually been raising interest rates, and expects to eventually get it to 3.4% or so in 2020.
You don’t even need to accurately predict how much and how quickly interest rates will rise to determine that bond returns are likely going to be poor. If interest rates do go up, then current bonds will reduce in value in the short term, but future bonds might produce a decent real rate of return. On the other hand, if we have a long era of fairly low interest rates, then it won’t badly impact current bonds, but all present and future bonds would continue have a low rate of return.
Ten year treasuries right now, for example, give you 1% real returns over their holding period. The interest rate that investors receive from holding them barely surpasses inflation. If interest rates remain low for long, bond returns will continue to be awful, barely keeping up with inflation.
Either way, without bond returns being propped up by a 35-year super cycle of interest rates descending from unprecedented highs to unprecedented lows, bond returns are likely to be disappointing. Low interest rates are bad for bonds in the long term. Rising interest rates are bad for bonds in the short term. High inflation, if we get it, is bad for bonds in all terms.
Foreign stocks won’t save us either
The standard index retirement portfolio, based on Modern Portfolio Theory, looks something like this:
A large part is usually allocated to American stocks (either just the S&P 500, or both large and small cap companies and maybe REITs), and then smaller chunks are allocated to bonds and foreign stocks. The bond component is usually allocated a larger and larger share as the investor ages. That’s standard practice.
The foreign index used by most indexers, including Vanguard, is distributed proportionally based on economic size, like the MSCI World ex-US index. In other words, a broadly diversified foreign index fund is usually heavily weighted into Japanese and European stocks, because those are the largest international economies, with smaller parts allocated to other countries like Australia, Canada, and possibly some emerging markets.
Read more here about why that’s a problem and how to fix it.
In short, Japan faces population shrinkage and the highest public debt-to-GDP ratio of any country in the world, and is the single largest area of concentration for these international indices, accounting for between 1/5th and 1/4th of their total holdings.
However, I do think a decent weighting in emerging markets may help boost returns over the next 10-20 years. They have better growth prospects and rather low valuations.
Lower Index Fund Expectations
Rather than expecting 8-12% returns from stocks and 5-7% returns from bonds like we have in the past, it’s more realistic to expect less than 8% stock returns and less than 4% bond returns going forward. A balanced portfolio of stocks and bonds is likely to provide maybe 5% returns over the long-haul, and even less than that if we adjust for inflation, taxes, and fees.
Of course, we can’t know for sure. Maybe we’ll buck the trend of the last century and a half of data and have great returns despite a currently highly overvalued market. Maybe despite all the structural problems of an aging population, unprecedented health care and education costs, an economically hollowed-out middle class, a massive public pension retirement problem, and competition from low-cost emerging country labor, we’ll somehow enter a new era of prosperity like we’ve never seen before.
But I wouldn’t bet on it. Would you plan your retirement around historical 9% annualized rates of return when all the evidence suggests that both bonds and stocks will do worse?
Base your savings rate on pessimistic forward return estimates, not optimistic ones. It’s better to be pleasantly surprised than unpleasantly surprised.
Socially Responsible Investing, Or Lack Thereof
Index funds are in many ways the opposite of socially responsible investing.
Corporations are increasingly being owned by passive asset managers, who are not just passive with their investment decisions, but are also passive with their corporate governance. They generally don’t scrutinize candidates for the boards of companies they own, and they almost always abstain or vote no on shareholder proposals.
For more detail on this topic, read this article.
Millions of investors around the world have turned to automatic indexing.
Mounting evidence against the high-fee actively-managed mutual fund industry and in favor of the past performance of indexes has helped propel this trend, and the surge of personal finance blogs and forums over the last decade and a half have further supported this purely passive indexing movement.
But could the pendulum have swung too far?
Has the shift from active management to passive management gone to an unnecessary extreme, where investors set a fixed investment plan in stone and refuse to ever modify it based on market conditions?
There’s a good chance that people are setting themselves up for lackluster returns and a less comfortable retirement than they expected based on extrapolations of past data.
Even institutional investors are likely over-estimating their future returns.
According to the National Association of State Retirement Administrators, state pension funds currently plan for 7.5% annualized returns from a mix of stock and bond portfolios. That’s far from a conservative plan, considering that all the previously mentioned valuation metrics suggest returns will be lower than that.
Considering that combined state pension funds are quickly approaching $1.75 trillion in unfunded pension liabilities, and these liabilities are growing at a compounded 18% per year, both pensioners and taxpayers have a growing problem on their hands partly due to overestimating the rate of return that indexed portfolios can reliably provide. This is going to hit the fan the next time we have a major market correction, when suddenly the $1.75 trillion in unfunded liabilities expands to $3 trillion or more.
So, even folks who aren’t in the market and rely on other retirement income, may be hit hard by the people investing on their behalf.
Idea #1) Save and invest more money
This is the least sexy approach, but important nonetheless.
Investors should plan for 4-5% returns rather than 7-10% returns. Put more money away so that you require lower returns to meet your goals.
It’s simple, but hard, especially because middle-class inflation-adjusted wage growth has been flat while healthcare and education costs have skyrocketed. There’s little other choice right now, though.
And if returns somehow are better than all the data suggest, then great! You’ll have more money.
Idea #2) Make rational adjustments
Consider using a light-handed active touch on your otherwise passive portfolio.
When market valuations approach historical extremes, there’s good evidence that adjusting the weighting accordingly can help your portfolio outperform. When equity valuations are high, it makes sense to reduce exposure. When equity valuations are low, it’s not a bad idea to increase exposure.
Backtesting over a century shows that a stock/bond portfolio that is automatically tweaked based on the Shiller P/E outperforms a static stock/bond allocated fund. In other words, when the Shiller P/E starts to get high, allocate a bit more heavily to bonds. When the Shiller P/E becomes low, allocate a bit more heavily to stocks.
Idea #3 Focus on income generation
They’re underused strategies that do exceptionally well in exactly this kind of market environment, because they can generate 10% or more in income and returns even when the market is flat.
A portfolio that incorporates put-selling and covered calls does very well in flat, sideways, choppy markets, while also giving decent returns in bull markets and reducing your downside risk in bear markets.
Gimmicky strategies that rely on just one tactic, like a pure covered call selling strategy, are not smart. Instead, using different tools for different market environments makes sense. And right now, selling options that can give you a lot of income in a flat market, and that can give you decent downside protection, are one of the more powerful tools you can employ.
In addition, focusing on safe high dividend stocks can help you weather periods of low returns. An attractively-valued stock with a 4-6% dividend yield, growing it at 2-5% per year, can give pretty solid returns through a business cycle.
How I Invest
Personally, my primary retirement account consists of a simple set of index funds that automatically re-balance themselves. The only thing I do, is monitor the CAPE ratio of the U.S. market, and slightly reduce equity exposure if it goes over 30, and slightly increase my equity exposure if it goes closer to 20 or lower. During most years, it therefore remains untouched. I also take into account some other valuation metrics and business cycle indicators.
My Roth IRA and taxable brokerage accounts have indexed ETFs, and also make use of individual dividend-paying stocks in industries I have a lot of experience with (including REITs and MLPs), conservative income-based options positions, and a little bit of precious metals for diversification. This is my more hands-on approach, in the sense that I open it and tweak it every month or two.
Compared to my primary retirement account, my other accounts are more income-focused, less volatile, and have exposure to more asset classes.
While index funds have been an incredibly important investing strategy, there are appears to be over-enthusiasm for what they can do, both among institutional and personal investors. For some people, there’s also a devotional approach of never adjusting the investment strategy to keep up with new market conditions.
Investors don’t necessarily have to be bound by S&P 500 returns, and active portfolio management doesn’t necessarily have to mean “picking hot stocks” hoping for blockbuster returns.
Instead, it can mean a patient focus on high income generation to outperform in the face of overvalued slow-growth equity markets and low bond yields, or can mean mild adjustments to take into account unusual market valuations.
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