Should Index Funds Rule?

In a recent Wall Street Journal article, columnist Jason Zweig suggests that investors think outside the box when it comes to index investing.

Zweig argues that even if you invest primarily in index funds, “you may well buy a few stocks on the side,” citing a 2008 study showing that “wealthier individuals who directly owned only one or two stocks outperformed those who are more diversified by about percentage points annually—and up to nearly six percentage points when the stocks weren’t in the S&P 500.”

The article outlines some of the potential benefits of investing a small amount in “orphan stocks”—those that aren’t held by index funds (due of their smaller sizes, limited shares outstanding, limited voting rights or other reasons). Most ETF’s, writes Zweig, “shun stocks with total market values below $100 million.” But while these so-called microcap stocks can be volatile, Zweig points out, since 1926 they have outperformed the biggest stocks by an average of 3 percentage points a year.

Many microcap stocks, Zweig writes, are trading at close to book value and “often for as little as four times the cash their businesses generate—fractions of what the stocks favored by index funds sell for.” He concludes that the asset class could prove lucrative for investors who can be “picky and patient.”