Challenging The Index
Index funds are incredible tools. They are perhaps the single largest contributor to wealth-accumulation in the modern era. Index funds are collections of stocks held in fund with a few key features that make them powerful long-term investment tools.
Low Fees. Index funds passively track a particular index (think S&P 500, Nasdaq 100, Russell 3000, or even the Total Market). Any stock that is added to the index is automatically added to the fund— this means the fund doesn’t require active management like mutual funds or many ETFs— which allows index funds to charge exceptionally low fees to own.
Self-Cleaning. Another feature of being actively managed means any stock removed from the index is removed from your fund— this means the index fund you own is constantly adding new up-and-comers, and removing companies that under-perform. This feature means you essentially never have to sell the fund— even if the stocks in the fund change over time.
Diversification. By owning a single index you are diversified across hundreds, or even thousands, of stocks. Even if a company in the fund goes to zero, your portfolio hardly notices.
These features make broad index funds remarkably simple and difficult to improve upon over long periods. Index fund investing is one of the most proven long-term investment strategies.
So why challenge the index?
Many of the same features that make index funds successful long-term investments are also what leave the most room for improvement.
Index funds are self-cleaning— but this isn’t a fast process. Index funds own a lot of good companies— and quite a few bad ones too. Consider this; on any given year more than half of the stocks in the S&P 500 underperform the S&P 500. That means more than half of your portfolio is dragging it down.
Obviously it isn’t as easy as “keeping the good half,” but finding real improvement isn’t impossible either. There’s a lot of room to improve your returns simply by taking out the trash.
In the age of information we are only a few clicks away from getting nearly limitless amounts of information about the companies we invest in— and increasingly powerful analytical tools such as AI make it easier than ever to analyze hundreds of companies systematically.
I view index funds as the best “set-it and forget-it” strategy to grow your wealth. I also view low-fee index funds as perhaps the best place to park much of your money once you have reached your saving / retirement goals.
Consider this scenario— Imagine you were offered to purchase one of two portfolios:
The first is a portfolio of 100 gas stations throughout the country— you would own 1% of each gas station— some are highly profitable in competitive markets with the best management teams running them, while others are in distressed markets, with low profit margins and significant regulatory risk.
The second portfolio is 25% ownership in 4 of the best gas stations from the portfolio of 100.
Which portfolio contains the better businesses?
The 100-station portfolio clearly provides greater diversification. But diversification and business quality aren’t the same thing. At some point, diversifying into progressively weaker businesses may provide diminishing benefits.
I’m not making a case against diversification, it’s an important tool for your long-term portfolio, but I am trying to illustrate that challenging the index by choosing high-quality businesses to own has its merits.
Indexing solves the problem of picking winners by owning almost everything. That works extraordinarily well because a relatively small number of exceptional companies can generate enough wealth to more than offset a large number of mediocre and poor performers.
But it also creates an opportunity.
The goal isn’t necessarily to identify the next Nvidia before everyone else. Nvidia (NVDA) is up nearly 1600% since 2020, but you didn’t need to own NVDA at the beginning of its run to benefit enormously from its success.
I know, hindsight is nice, but we couldn’t know NVDA was going to keep running higher, right? For the sake of argument let’s say we couldn’t. Perhaps the lowest-hanging fruit to beat the index improve your portfolio is actually in the lowest-hanging fruit— meaning eliminating the worst performers in the funds.
One of the most obvious examples to me is DISH Network (DISH). Would you really have bought Dish Network once streaming was widely available?
DISH remained in the S&P 500 while its core business deteriorated for years. The index eventually removed it, but only after investors had already absorbed significant underperformance.
If deteriorating businesses can be identified systematically before they are ultimately removed from an index, avoiding even a portion of that underperformance could meaningfully improve long-term returns.
That is the challenge: not predicting every future winner, but developing a disciplined process that keeps broad exposure to strong companies while identifying persistent laggards before the index itself finally removes them.
All of this to say it’s not unreasonable to build a better return.
How much better? Read ahead on what a 1% difference makes to your portfolio…
This article is for educational purposes only, it does not guarantee a return or eliminate risk, but purposes to express the opinion of the author.
