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Ignore the "Experts." Index Funds Are for Chumps

Editor’s Note: A previous version of this article blamed the underperformance of the S&P 500 vs. the Dow Jones Industrial Average partially on Alcoa and Hewlett-Packard, even though Alcoa and Hewlett-Packard are components of both. We’ve revised the article. The Motley Fool regrets the error.

"There are two sensible approaches to investing, either 100% active or 100% passive. Unless an investor has access to incredibly high-qualified professionals, they should be 100% passive. That includes almost all individual investors and most institutional investors."

So says David Swensen, chief investment officer of Yale University's $19.4 billion endowment, in a recent interview with Bloomberg.

Unfortunately, most of us don't have $19.4 billion to work with, or the access to pricey hedge fund honchos that such lucre buys. And even if we did, Swensen is right -- it's hard finding a surefire "high-qualified professional" even if you've got the money. Last year, for example, the average value-based equities hedge fund lost 20%. And that was in a flat market.


Don't even try to beat the market
So does this mean we have no choice but to sock our money away in a boring old S&P 500 index fund and forget about it? After all, Swensen isn't the only person urging investors to quit trying to beat the market and just "let it ride." A lot of smart folks agree with him. People like...

Warren Buffett: "The best way to own common stocks is through index funds."Charles Schwab: "Buy index funds. It might not seem like much action, but it's the smartest thing to do."And Nobel laureate (in economics, no less) William Sharpe: "Most of my investments are in equity index funds."

Smart folks, every one. And they might be right, if it weren't for one thing: There are a lot of really lousy companies in the S&P 500. Anytime you invest in an S&P index fund, you're automatically buying them. Sure, you get some good companies, too -- Apple, Akamai, and American Express (and that's just the A's). But you also get all of the bad ones.

Index funds would be great, if it weren't for Alcoa...
Over the past 12 months, your average S&P 500 index fund gained 6%. But one of the largest components of any S&P 500 fund, Apple, was up more than 81%. Even with such a large weighting -- Apple makes up more than 3% of assets in Vanguard's 500 Index Investor fund -- it couldn’t raise the index beyond the 6%. Of course, it would have done better if not for the "bad apples" in the S&P, stocks like...

Alcoa (NYSE: AA - News)
Profitable and pegged for 20% earnings growth over the next five years, Alcoa should start doing well any day now -- but that day never seems to arrive. The company is profitable but is earning only a fraction of what it brought in five years ago. Even if the economy does recover, Alcoa's persistent debt load ($7.4 billion and counting) will prevent the company from taking full advantage of improved demand for its products.

United States Steel (NYSE:X - News)
If there's one thing you can say in favor of Alcoa, it's that it's at least in better shape than U.S. Steel. Where other metal makers burn coal to help smelt their steel, U.S. Steel prefers to burn cash. Unprofitable and $3.8 billion in debt already, U.S. Steel burned another $680 million in cash last year.

Hewlett-Packard (NYSE: HPQ - News)
And it's not just smokestack industries dragging the S&P 500 down. The index has plenty of high-tech lemons as well. For example, when Hewlett-Packard bought Compaq, bulls hailed the creation of a tech goliath that would crush Dell and Apple alike. Instead, they got an unwieldy tech empire, cobbled together largely by acquisition, often with little thought given to what was being acquired. Result: $10 billion wasted on a previously unheard-of British software company called "Autonomy." And $1.2 billion to purchase Palm, which HP no sooner bought than it turned around and shut it down. Ugh.

Netflix (Nasdaq: NFLX - News)
And then there's Netflix. After the double-header of a fiasco that was last year's price-hike-cum-name-change, Netflix deserves a space in business school textbooks for decades, a whole chapter on "how to ruin a brand in 80 days or less." When your stock is trading in the triple digits, and overpriced by any reasonable standard -- that's not a good time to invite extra scrutiny with headline-grabbing moves to double the price of your movie service. And dumping a great brand name to replace it with "Qwikster"? Madness.

Twenty great reasons not to buy an index fund
Alcoa and U.S. Steel. Hewlett-Packard and Netflix -- these are just four of the nearly 20 companies on the S&P that managed to lose 30% of their market cap over the past year. And lucky you -- if you follow the advice of Buffett and Schwab, Sharpe and Swensen, you just might be "fortunate" enough to own a piece of every one of them.

Motley Fool contributor Rich Smith does not own shares of any companies named above. The Motley Fool has a disclosure policy. The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Netflix and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Motley Fool newsletter services have recommended writing covered calls on Dell. Motley Fool newsletter services have recommended creating a write covered strangle position in American Express.