Beyond the Average: Why Index Funds May Not Be Enough
To my partners,
In this journal, I'll share my thoughts on index funds, a topic that has garnered significant attention in the investment community. My goal is to provide a balanced and rational perspective, drawing from my own experience and research. While I'm not advocating for any particular approach, I hope to provide valuable insights that can inform your own investment decisions. As always, I encourage you to do your own research and consider your individual financial goals and risk tolerance.
The focus of this discussion will be on the S&P 500 Index fund, a collection of the 500 largest and most stable companies in the United States. This index allows anyone to have diversified exposure to American businesses through a single investment. By investing in the index, you essentially own a tiny piece of 500 leading American businesses.
A common notion is that investing in an index fund can yield average annual returns of around 10% over the long term. However, I believe it's wrong to expect such high returns from the index over the long term, especially after taxes, inflation, and net of fees. The past performance of the index is not necessarily indicative of future results. As the saying goes, "No man steps in the same river twice. You know the rivers’ different the second time he comes in and so is the man."
To quickly estimate expected future returns, consider the earnings yield on the index. If the index is trading at 28x earnings, the expected return would be 1/28, or approximately 3.6%. However, this calculation has limitations. The "E" in the earnings yield equation is based on the trailing 12 months of company earnings, which can grow or decline, changing the expected return. Additionally, the "P" or price fluctuates daily, further distorting the expected return. Of note: you can try this with bonds as well. Assuming a bond is selling for par with a 4.5% yield — 100/4.5 = 22.2x earnings.
The earnings yield provides a snapshot of the return you would expect based on current price and earnings. It's unreasonable to expect that business earnings won't grow in the future, especially considering the major contributors to the index, such as Amazon, Google, Meta, Apple, and Nvidia, are likely to experience earnings growth over time. If you bought the index today at 28x earnings and aggregate earnings grew at 8% on average over the next 20 years, you would return more than the initial 3.6% expected earnings yield.
However, with the index's outperformance over the past 5-10+ years, many American portfolios have likely been purchasing more shares when the index is overpriced. The greatest threat to investment returns isn't a poor business model or lackluster management – it's overpaying. Even a great business purchased at an excessive price can turn into a bad investment. Most investors participate in dollar cost averaging when purchasing an index fund: buying the index at various price points.
There's a broader implication to this trend. As asset values have risen, market distortions have grown more pronounced. The increasing dominance of passive investing in index performance raises questions about the sustainability of past returns in the face of large capital inflows. Index funds allocate capital according to market weightings, which means that the largest market capitalizations – such as the "Magnificent Seven" – receive disproportionate investment. This influx of capital drives up their share prices, potentially disconnecting their market valuations from their underlying business fundamentals. The question then becomes: are these companies' valuations driven by their economic performance or by the mechanical buying pressure from index funds? Given the unprecedented levels of capital flowing into index funds, it's unlikely that past performance can be replicated indefinitely. As such, investors should temper their expectations, recognizing that returns may differ significantly from those achieved when the index and its constituent companies were trading at lower valuations.
While the math might point to more moderate returns in the near future, I’m also not entirely pessimistic about the index. I truly believe that for someone who doesn't want to spend their time dissecting company financials and business economics, investing in a broad basket of securities over the long haul (think 10, 20, 30 years) is still the best (and only) way to build wealth in the stock market. Yes, it sounds a bit contradictory to say, "Don't expect stellar returns from the index right now," and then follow it up with, "But it's not so bad." But here's the thing: long-term market growth has historically outweighed short-term fluctuations, and that's the key takeaway for long-term investors. If my expectations are the reality, when investing in index funds through dollar-cost averaging, prolonged high valuations will necessitate a longer investment horizon to ride out market volatility and capitalize on future downturns. By extending your time horizon, you can better average out returns and maximize the benefits of compound interest.
Furthermore, the landscape of index investing has changed dramatically. Access to investment in the stock market is easier than ever before, mainly due to reduced transaction fees. This has led to more “players” in the game, with entrants who would have otherwise been turned away by $20 per trade fees now buying and selling with simply a bet on upside or downside movements in stocks without any regard for business value and transaction costs. Wall Street has caught on and is now pushing more products that excite speculators with the intent of facilitating transactions and collecting a fee. The line between investing and speculation has never been blurrier, with market behavior resembling a casino more than a bastion of rational decision-making.
The shift towards ETFs is a prime example. In 1998, the typical index fund held 503 stocks. By May 2025, that number has been reduced to 123. ETFs often hold fewer stocks than traditional index funds, drifting further from overall market performance. Wall Street collects higher fees on these products, getting paid for activity rather than results. This raises questions about the true value of index funds. You buy an index fund because you don't want to spend your time picking individual businesses, but instead of getting the entire market and accepting the average, Wall Street offers "alternatives" that focus on narrow market niches or "themes." But are you really getting a better investment, or are you just paying more for less diversification?
The situation worsens with the rise of leveraged single-stock ETFs, now accounting for over $23 billion in assets under management. Daily trading volume has more than doubled in the past year, with Wall Street raking in fees on these products. As Charlie Munger wisely put it, "Even the smartest men can go broke if they fall for three traps – liquor, ladies, and leverage." People pile into leveraged ETFs hoping to amplify their gains but forget that leverage also amplifies losses. At Time Horizon LP, we’ll never get involved in transactions that reflect this mentality and I hope you’ll never too.
Altogether, I suggest you think carefully about whether an index fund or ETF or any other investment product is truly the best use of your capital, compared to an investment in Time Horizon LP. Our focus is on investing in exceptional companies that meet rigorous criteria. I believe this concentrated approach, over time, is more likely to deliver above-average returns compared to the broader market index. For people who don't invest with Time Horizon LP, buying the index will likely be the best way to deploy their capital. But if that's your route, you need to be realistic about your return expectations and adjust them lower than historical averages.
Kyle Delmendo
Founder, General Partner, CIO