Songs of Surrender: Index fund problems and nobody knows anything

Earlier this year, U2 released Songs of Surrender, a collection of 40 acoustically re-recorded classics. The band that wrote bangers like I Will Follow and A Sort of Homecoming somehow managed to suck the life out of every single track, creating a collection of elevator music that only the most die-hard fan could struggle through more than once.

This week’s newsletter is also going to rehash some classics, but I hope I do it far better than Bono and the boys did.

More Index Fund problems

Aside from the fact that the S&P 500 is once again a shitty index, there are issues with other relevant indices. You may believe you’re doing the responsible thing by investing in something like the iShares S&P 500 Value Index. Sure, growth stocks, led by the likes of Tesla and Nvidia, are going crazy, but there is relative safety in the value end of the market, right?

Think again! As this Wall Street Journal article points out, your “value” ETF counts among its top holdings stocks like Microsoft (37x P/E), Meta (36x), Amazon (302x), Salesforce (N/A), and Netflix (47x). Microsoft itself makes up a not-so-prudent 6.23% of the value of the holdings as I write this - a high concentration in what looks like a very expensive stock.

While I’m not necessarily anti-index fund, they are not a “set it and forget it” proposition for most wealthy investors. There is too much at stake to delegate your portfolio to the type of committee that would designate these as significant holdings in a “value” fund. Index funds require a layer of active management to understand and manage risk, and that extra layer often negates any cost advantages they’re supposed to possess. As I wrote in Low Risk Rules, “there is no such thing as passive investing, and that’s a good thing!”

Nobody knows anything, redux

I’ve written before about the idea that “nobody knows anything.” So far, 2023 is certainly living up to that axiom.

Let’s start the tour in Europe. It was a seemingly foregone conclusion that Russia’s invasion of Ukraine would spell doom for European markets. In fact, over the past year, France and Germany have been the world’s top performing stock markets, and by a wide margin. This is certainly not an outcome anyone had on their bingo cards last spring!

Next, let’s take a look at interest rates. It seems like ancient history, but as recently as last March the effective US Fed Funds rate was 0.25%. It was at that March 2022 meeting that the Federal Reserve decided to raise rates by a modest quarter point. The Fed also produces a famous “dot plot” chart that displays the predictions of the Fed governors themselves – the very people in charge of setting interest rates. In March of 2022, most of them saw 2023 rates settling in between 2% and 3%, with only a few dissenters predicting rates might rise as high as 3.75% this year. Oops. At their May meeting, the Fed raised the target overnight rate to 5.25%, blowing away their own predictions, made just 14 months earlier. If the Federal Reserve members themselves were so far off the mark, what chance does anyone else have?

How about the stock market? One would reasonably assume that with interest rates moving so much higher than expected in such a short period of time, stocks would have been a primary casualty. Rising interest rates were supposed to be the death knell for “long duration” expensive tech stocks, which is why they performed so poorly in 2022. But so far this year they have rallied strongly, with investors betting on an Artificial Intelligence renaissance to inflate yet another technology stock bubble. Anyone who might have seen this stock rally coming probably did not think it would be possible in conjunction with the unprecedented and unexpected rise in interest rates.

It’s true - nobody knows anything.

So what does that mean for your portfolio?

First of all, we know that it’s futile to attempt to time the stock market. You might get lucky once or twice, but over time it’s a losing bet. It can be hard to resist the temptation when the front page of the business section is telegraphing how good (or bad) business is going, but as we have seen time and time again, so very often the “obvious” opportunities to buy or sell are no such thing.

Second, the one asset class that has proven itself over time is equities. The volatility of stock prices can mask the fact that over time, owning high quality businesses is the most reliable way to grow wealth and protect against inflation. 

Finally, in times of stress, a conservative investment strategy should outperform. We saw it last year, when growth stocks were punished by the rise in interest rates. If the stock market or economy were to hit another air pocket, it is likely that market leadership would revert to those higher quality, lower volatility stocks. Rather than attempt to time the market, sticking with this evergreen strategy allows you to tune out the noise and focus on what matters.