A Bailout for Index Funds? Not Likely

Wall Street as we knew it has disappeared. A huge bailout may happen. This is a fine time to assess what works and what doesn't.

Here is a list of some of the biggest names in the index fund world. I call it the "good" list.

Vanguard
Barclays
State Street
Fidelity
Dimensional Fund Advisors
T. Rowe Price
Schwab

Here is a partial list of troubled firms that have been affected by the recent financial meltdown. You can guess what I call it:

Lehman
Goldman Sachs
Morgan Stanley
Wachovia
Bear Stearns
Merrill Lynch

Many observers believe this is only the tip of the iceberg.

It is not entirely surprising that the shocking lack of competence of these firms resulted in their downfall. One study found that 94% of 50 major brokerage and investment banking firms continued to recommend investors buy or hold shares in failing companies right up to the day those companies filed for bankruptcy.

None of the firms on the "good" list need a bailout.

These firms sell investment products everyone can understand. They use a benchmark. The fund tracks the benchmark and captures the returns of that benchmark, less low transaction costs.

Their products don't have "sizzle"--unlike complex financial instruments like collateralized mortgage obligations, initially created for the defunct Freddie Mac.

The boring firms are now in the position of bailing out the really exciting ones.

What we are witnessing is more than the restructuring of Wall Street. It should also fundamentally change the way we invest and the kind of information upon which we rely.

Even the most committed returns-chasing investor must pause and reflect on a system in which trusted sources of investment advice have been so wrong. One of the most egregious examples is Standard & Poors analyst report on Washington Mutual issued September 24, 2008, one day before WaMu was taken over by the FDIC. Its deposits were sold to JP Morgan. The report advised investors to "hold" the stock and set a 12 month "target price" of $4 a share.

WaMu is currently trading at 16 cents a share.

The silver lining in the dark clouds is that the new paradigm for investors is so clearly in their best interest.

Just because the government is thinking about bailing out Wall Street doesn't mean you have to continue to follow suit.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

Comments

[wordsaway]

Dan,

Please tell me how you rate Smith/Barney and American Funds. Lastly, in some future posts will you cover the great controversy around bonds that has been swirling over the last few years. Some advisors staying clear of them - regardless of age of investor, etc.

Big thanks!

[schatsie]

That list explains EXACTLY why I am opposed to ANY BAILOUT UNLESS the terms are as good as or better than those that BUFFETT or any other BIGTIME INVESTOR gets.

[nezumi]

I also read the post because of the heading - and found not much what I expected.
.
If there is no bailout for Index funds (or index-bases certificates, I am not a banker) are certainly interesting. These papers are often bought by investors who are risk-averse, instead of buying individual shares. If there is no bailout a lot of people will be hurt - and, most importantly, unexpectedly.

When you buy individual shares, your only worry is that that company goes bancrupt. When you buy an index fund, you think that you have shares from several companies, thus hedging a bit better against any one company from going bancrupt.

Two years ago I was tempted to buy index-related paper (the index fared so much better than the individual shares I held) and decided against it, but mainly because of my own paranoia: I thought, who guarantees that the issuing entity (bank) does not go bancrupt itself? At that time this worry seemed vastly exaggerated and overly paranoid.

Well, being paranoid does not mean others are NOT after you.

[fredlonsdale]

I get your point and I generally agree with you. However, why did you use the term "Index Funds" in your headline and then not have Index Funds as your primary topic.

The good firms you list may sell a few index funds, but Vangaurd, as far as I know, is the only firm that emphasizes the principles of minimizing investment expenses, diversification, index fund investing etc.

[cylindar]

Yes, it will be a new paradigm for investors. Wall St. will become less of an actor in the investment arena. I would expect that a new design will shake out solid within the next five years. Global investment regulatory agencies may become part of the new movement. Off Wall St. investments will become popular just like off broadway plays because they will not be exposed to regulation. Yes, there is a new game coming to town. For the most part the cash cow is going for the investment "banksters". I am sure however that they will find their niche somewhere.

[larry278]

Their niche will involve incarceration & a life time ban from being involved in what we now call the financial industry. They will be forbidden to even make change to break a coin or a bill, on or off Wall St. Their niche will resemble a coffin or a dog pound. Persons of their ilk will not ever be permitted to be at large. Their activities will be very restricted similar to a dog being muzzled & kept on a very short, & strong leash fastened to a strong, large anchor or fastened securly to its personal keeper by means of a secure, locked waist chain, leg irons or hand cuffs. These people are dangerous creatures. They will be allowed to accept unrelenting restrictions or they will be put to death in a humane way similar to the fate of a mad dog.