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5 reasons to avoid index funds

Index funds are all the rage these days – due to modern portfolio theory, which holds that markets are efficient, and that a security’s price includes all available information. Therefore, advocates argue, active management of a portfolio is useless, and investors would be better off simply buying an index and going along for the ride. However, stock prices do not always seem rational, and there is also ample evidence going against efficient markets. So, although many people say that index investing is the way to go, we’ll look at some reasons why it isn’t always the best choice. (For background reading, see “Modern Portfolio Theory: An Overview.”)

5 Reasons To Avoid Index Funds

1. Lack of Downside Protection

The stock market has proved to be a great investment in the long run, but over the years it has had its fair share of bumps and bruises. Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside. You can choose to hedge your exposure to the index by shorting the index, or buying a put against the index, but because these move in the exact opposite direction of each other, using them together could defeat the purpose of investing (it’s a breakeven strategy). (To learn how to protect against dreaded downturns, check out “4 ETF Strategies For A Down Market.”)

2. Lack of Reactive Ability

Sometimes obvious mis-pricing can occur in the market. If there’s one company in the internet sector that has a unique benefit and all other internet company stock prices move up in sympathy, they may become overvalued as a group.

The opposite can also happen: One company may have disastrous results that are unique to that company, but it may take down the stock prices of all companies in its sector. That sector may be a compelling value, but in a broad market value weighted index, exposure to that sector will actually be reduced instead of increased. Active management can take advantage of this misguided behavior in the market. An investor can watch out for good companies that become undervalued based on factors other than fundamentals and sell companies that become overvalued for the same reason. (Find out how to tell whether your stock is a bargain or a bank breaker in “Sympathy Sell-Off: An Investor’s Guide.”)

Index investing does not allow for this advantageous behavior. If a stock becomes overvalued, it actually starts to carry more weight in the index. Unfortunately, this is just when astute investors would want to be lowering their portfolios’ exposure to that stock. So even if you have a clear idea of a stock that is over- or undervalued, if you invest solely through an index, you will not be able to act on that knowledge.

3. No Control Over Holdings

Indexes are set portfolios. If an investor buys an index fund, he or she has no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy. Similarly, in everyday life, you may have experiences that lead you believe that one company is markedly better than another; maybe it has better brands, management or customer service. As a result, you may want to invest in that company specifically and not in its peers.

At the same time, you may have ill feelings toward other companies for moral or other personal reasons. For example, you may have issues with the way a company treats the environment or the products it makes. Your portfolio can be augmented by adding specific stocks you like, but the components of an index portion are out of your hands. (To learn about socially responsible investing, see “Change the World One Investment at a Time.”)

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4. Limited Exposure to Different Strategies

There are countless strategies that investors have used with success; unfortunately, buying an index of the market may not give you access to a lot of these good ideas and strategies. Investing strategies can, at times, be combined to provide investors with better risk-adjusted returns. Index investing will give you diversification, but that can also be achieved with as few as 30 stocks, instead of the 500 stocks that the S&P 500 Index would track.

If you conduct research, you may be able to find the best value stocks, the best growth stocks and the best stocks for other strategies. After you’ve done the research, you can combine them into a smaller, more targeted portfolio. You may be able to provide yourself with a better-positioned portfolio than the overall market, or one that’s better suited to your personal goals and risk tolerances. (To learn more, read “A Guide to Portfolio Construction.”)

5. Dampened Personal Satisfaction

Finally, investing can be worrying and stressful, especially during times of market turmoil. Selecting certain stocks may leave you constantly checking quotes, and can keep you awake at night, but these situations will not be averted by investing in an index. You can still find yourself constantly checking on how the market is performing and being worried sick about the economic landscape. On top of this, you will lose the satisfaction and excitement of making good investments and being successful with your money.

The Bottom Line

There have been studies both in favor and against active management. Many managers perform worse than their comparative benchmarks, but that does not change the fact that there are exceptional managers who regularly outperform the market. Index investing has merit if you want to take a broad economic view, but there are many reasons why it’s not always the best route to achieving your personal investing goals.

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Four Reasons Why We Need Dynamic Scoring

The Joint Economic Committee hearing last week discussed the importance of dynamic scoring ­­—a method of estimating the effects of policy changes on the economy. Earlier this year the House of Representives passed a rule requiring dynamic scoring of future bills. Congress had previously relied on conventional, static scoring to analyze such effects. Static and dynamic scoring are very different in the assumptions they employ, and therefore the results they produce.

Static scoring assumes that tax changes don’t affect behavior of individuals and firms, and therefore have no impact on growth. Dynamic scoring, on the other hand, assumes that tax changes influence the amount of savings and investment—the engine of economic growth. As the amount of savings and investment change, the overall economy changes as well. Failing to take account of such a simple economic relationship results in misleading forecasts.

The need for dynamic scoring was recently emphasized to the committee by four prominent experts on the matter. Their main points were as follows.

1. We need to understand the real cost and benefit of a policy proposal

When Congress enacts a policy, it needs to have an idea of how that policy affect taxpayers, businesses, and government revenue. However, the static estimates that Congress has been using as a guide hide the true cost/benefit of a policy change. This was the view presented by Dr. Phil Gramm, former Chairman of the US Senate Committee on Banking, Housing, and Urban affairs. In his testimony, Gramm argued that:

If a policy change is likely to affect the economy, based upon a logically consistent theory, and good empirical evidence that similar policies have had significant effects on the economy in the past, we should always attempt to employ dynamic scoring.

2. The effect of taxes on economic growth is part of the policy debate

In a world of increased global competitiveness it is imperative that the US government adopt policies that promote competitive economic growth. Dynamic scoring estimates the effect of policy changes on economic growth. Without dynamic scoring, lawmakers won’t have the information necessary to select policies that most benefit the economic health of the country. As Dr. John Diamond from the Baker Institute of Public Policy argued, “We can’t afford policy changes that don’t create growth.”

3. Without dynamic scoring, tax reform discussion is going nowhere

Major reform of the US tax code – broadening the tax base and making rates more competitive – can improve the wellbeing of Americans. But tax reform has not been seriously discussed since the 1980’s. The US is now ranked third last on the International Tax Competitiveness Index. Dr. Kevin Hassett, an economist at AEI, stated before the Committee that “one reason we have made such little progress is that scoring methods do not account for the impact that sound proposals would have on the overall economy.”

4. Conventional scoring underestimates the benefits of tax cuts

Because of the assumptions behind conventional scoring, the benefits of tax cuts tend to be underestimated.

Dr. Gramm gave an example during his testimony on how far off CBO’s static projections were compared to reality. CBO predicted that the bipartisan “Balanced Budget Act and the Taxpayer Relief Act of 1997” — an attempt to balance the budget by spending cuts and tax cuts — would create $120 billion revenue between 1995 to 2001. In reality, nominal GDP between 1997 and 2001 beat CBO’s expectation by $2.4 trillion. That averaged out to be $480 billion per year higher than CBO’s forecast. That piece of legislation added an extra $8,609 in per capital GDP during those five years.

Skeptics would argue that dynamic scoring is merely a tool to justify a tax cuts without having to pay for them. Ranking Member Rep. Carolyn Maloney (D-NY) stated in her remark that dynamic scoring “strongly biases policy towards tax cuts.” But history proved tax cuts actually stimulated growth.

Dr. Hassett explained why conventional scoring underestimates the benefits of tax cuts and why dynamic scoring is a better tool for Congress:

In a world of conventional scoring, no tax cut can be estimated as likely to “raise all ships” by raising the level of overall macroeconomic growth. This is because conventional scoring, by construction, only permits changes to the composition rather than the level of economic activity. Thus, current practice focuses one-hundred percent on questions of distribution, treating tax cuts as mere alterations in who gets the benefits of a fixed level of aggregate economic activity. Such a focus has no economic merit. Policymakers, of course, should consider issues of distribution when considering policy alternatives. But to look at distribution only, without regard to economic efficiency, is to deny the basic tradeoff between the two, and frankly, to deny the value of economic analysis whatsoever.

Dynamic and static scoring are both tools for providing Congress with the information they need to make decisions on tax policy, but there is a clear difference between them. As the Tax Foundation’s President eloquently put it:

Conventional scoring methods provide [congress with] a very one-dimensional perspective about the effects of tax changes. By contrast, dynamic scoring gives lawmakers three dimensional information they can use to understand the effects of tax policies on a complex, multi dimensional US economy

The gradual move towards dynamic scoring has been long awaited by advocates of a strong economy. It will help representatives make better policy decisions that will boost growth and improve living standards for all Americans.

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