The Pros and Cons of Index Funds
Hi everyone, and welcome back to Melissa Making Cents!
If you've been following the blog sequentially, CONGRATULATIONS! We've made it through covering annuities! More specifically, in the past three weeks, we covered the Annuity Basics, How Annuities REALLY Work, and Annuity Riders! And if you're interested in investing in annuities during this bear market, I'd highly recommend reading through those posts. They start with the basics (what an annuity is and how it works) and slowly progress into more detail, covering some of the fine print, sales tactics, and add-ons that come with them.
This week I want to continue some of the momentum we had while discussing annuities. If you'll remember, the main reason we started discussing them in the first place was their tendency to skyrocket in popularity during market downturns. Index funds, this week's topic of discussion, also tends to rise in popularity during challenging times!
Index funds are a fun topic, and they're easy to understand! That's part of the reason that they're popular among so many investors!
The Problem with Investing
Imagine that you are very interested in a particular industry and want to invest in it broadly. So, you go about building a fund filled with investments that are specific to that industry. That's great! It's something people do all the time. However, people who usually do this are professionals and well experienced with investing. Unfortunately, there are drawbacks to this plan… Perhaps you work a full-time job, giving you little free time to fully understand and research each company you want to invest in to build out this fund. Or maybe you can't quite get it just how you want it, so you continue tweaking it – which could lead to some high commission and/or costs. Or maybe you don't feel overly confident that you'll be able to pick all the right companies to invest in and are worried you'll over/under diversify.
The Solution – Index Funds!
Index funds are essentially a way to deal with those issues! They allow you to invest in specific market areas more easily without personally hand-picking each company or worrying about diversification.
Well, let's back up just a second… Index funds, as we know them, are truly mutual funds that track market indices. An actual financial index is a collection of companies/investments across a broad but specific market segment.
These funds are created to reflect the performance of a market index. One reason they're popular is that they come "pre-diversified." In other words, the market index that your fund tracks is diversified, so you simply need to invest in it. This is a great entrance strategy for novice investors that allows you to invest passively with slightly lower returns but lower fees than an actively traded fund.
How Index Funds Started
The idea for index funds can be followed back to 1960 when University of Chicago students created a theoretical model as a management-free investing tool. However, the first real index fund wasn't created until the 1970s when John Bogle, a Princeton University graduate, developed a mutual fund known as the Vanguard 500 Index Fund. This was later renamed the Standard and Poor's 500 Index (or the S&P 500).
The creation of the world's first index fund was met with heavy skepticism. However, it also created a small movement among academics and investors. While some didn't see the promise of a fund that only offered average returns, others thought the simplicity spoke for itself.
However, the index fund truly started to gain the interest of the general investing public in the 2000s as it surpassed Vanguard's largest offering, the Magellan Fund.
Why Index Funds are Seen as Good for New Investors
There are many reasons that index funds are seen as excellent starting points for new investors!
For starters, they work to build confidence. Now, that might seem like a silly point, but hear me out. Building confidence as an investor is something that is necessary. If investors aren't confident in their decisions, it can create chaos in their portfolios as they buy and sell too frequently because of small market fluctuations. An Index fund simplicity allows a new investor to feel out the market and get a bearing on how things work without having to be overly involved in the process.
Low fees are also a great reason that index funds attract new investors. Since index funds track and mimic the performance of indices, they have lower turnover and thus fewer transaction fees. Tracking an established fund also means that you're essentially eliminating the need for research analysts, which also saves money in fees. Less turnover in index funds also means that they'll be pretty tax efficient. Because you aren't selling stock as often, you could pay less in taxes on an ongoing basis.
Index funds are also typically passive investments. They're something you contribute to regularly and continue to buy and hold. This set-it-and-forget-it approach to investing is attractive to many investors, who may be wary of investing because of time constraints.
However, one of the most apparent reasons index funds are attractive to new investors is that they're perceived as low risk. This is because most index funds are comprised of a large number of company holdings, offering diversification among investing baskets. Many also believe that because there are a fair number of large companies in index funds, they're somewhat shielded from losing money. We'll talk later about why this may not be the case, but as far as attractiveness to investors, the perception is what's important.
Widely Tracked Indexes
Let's quickly discuss a few widely tracked financial indices. The movement and weight of these indices are what index funds are mimicking. This is because there are so many financial indices out there. This is a short list of the top three, but if there's a segment, basket, or area that you're interested in benchmarking, there's a financial index.
The Dow Jones Industrial Average, DIJA, Dow Jones, or the Dow is a financial index comprising 30 companies in the stock market in the United States. This is one of the oldest and most followed financial market indices and was first created to follow the heavy industry sector. However, as time has passed, this index has shifted to represent thirty of the most prominent companies on the market.
The Nasdaq composite index is a financial index that mimics the Nasdaq exchange. The Nasdaq exchange is the second largest stock exchange by market capitalization, and the Nasdaq composite index follows all the companies listed. However, unlike the Dow Jones, Nasdaq includes companies that aren't based in the United States and is known for being heavily tech-weighted (meaning there are a lot of technology companies included in the Nasdaq).
The S&P 500, which we've already talked about, is the first index fund. It's comprised of 500 of the United State's largest companies. These companies are chosen by both market capitalization and other issues and factors unique to each company.
Drawbacks of Index Funds
We've talked nothing but positively about index funds up to this point. HOWEVER, while I'm generally a fan of them, there are potential drawbacks to them (as there are with any form of investing) that should be discussed and seriously considered before making your move. In this section, we'll talk about some specific drawbacks to index funds; and, in the following sections, we'll discuss potential issues with index funds, how they perform, and how they function in a broader scope.
- Average Returns
Perhaps the most obvious drawback to investing in index funds is that because they mirror benchmarks, you won't get exceptionally high returns with them. However, it's true that while you're giving up some possible returns, you're also avoiding some risks. Index fund performance tends to sit around average and is typically slightly less than the financial index it is based on performs.
- Market Risk
Market risk is nearly impossible to avoid (if not impossible). With almost any investment or fund, you're susceptible to some market risk. One of the only ways to deal with market risk is to diversify your portfolio, which you can't do with most index funds as they're made to mimic an existing financial index.
- Lower Return on Investment
While this may seem the same as average returns, another downside of index funds is that they can give a lower return on investment than other forms of investment. Essentially, we're talking about the opportunity cost of creating a similar fund, but one that's more optimized and strategized than the broad stroke of a benchmark financial index.
- Reactive Ability/Less Control
While most financial adviser representatives try and train reactiveness out of their clients, it's always a good thing to have the option to drop an investment. Index funds, which (again) are modeled after benchmark financial indices, take that option away from investors. If a stock price is plummeting and it's obvious the company is going under, but an index benchmark doesn't drop it for whatever reason, your index fund is stuck with that failing investment.
Things like this don't happen often, but it's a possibility. For example, the S&P 500 held Enron while it fell from $80 to $1. The flip side of this is that Enron represented a tiny fraction of the S&P 500 at that point in time. As I said, things like this rarely happen, but they aren't unheard of either.
The Diversification Issue
One issue that often arises among investors is that there's a perceived diversification and a real diversification level with index funds. As I've stated throughout this article – Index funds are diversified. However, the problem isn't that they aren't diversified; the problem is that people believe some index funds to be more diversified than they are.
For example, Capital Investment Advisors outlines in an article how the S&P 500 is skewed by technology companies.
"One of the tenets of the S&P 500 is the diversification it offers. So, cap-weighted, we now have five stocks that make up almost 25% of the S&P 500 and nearly 45% of the Nasdaq. That's only 1% of the total stocks in the S&P 500, folks. This is an outsized concentration and one attributed to the current tech surge. With five stocks making up one-quarter of this $28 trillion index, it's hard to call the S&P 500 diversified."
They aren't the only ones either. TheStreet says, "But what's most striking is what's been happening more recently – since, February, the S&P minus those five names is still lower than it was just two months ago."
There's also an unrealized risk that's outlined by MarketWatch, which says that even though it's more costly, an actively managed fund may mitigate risks much better than an index fund. For example, one concern with many index funds is that they're partial to one country (typically the United States). Another unrealized risk people take with index funds is that they're beholden to a certain amount of popularity, which can get a company on an index and possibly keep it there longer than it should be.
Broken Leg Investing states, "Passive index fund investors typically earn returns much less than they planned on. And buying an Index Fund in today's world of sky-high equity valuations will make index investing performance even worse, dooming investors to terrible returns in the months and years ahead." They go on to say that investors only believe that they're passive and that truly they've only set a different point on when to make decisions – and not being wholly in control of those decisions isn't necessarily a good thing.
A Few Extra Considerations of Index Funds
Miscellaneously, there are also ruminations that the public overinvesting in index funds may be bad for the financial world and the United States economy. Some believe that co-ownership mixed with a population that is too reliant on passive investing leads to centrally planned returns and that that essentially takes risk and return out of the investing scenario.
Others believe that there's the possibility that the future of the United States economy holds a much bleaker picture for returns on index funds. Proponents of this idea say there's a possibility of a bubble caused by the popularization of index funds and that realizing this issue could cause returns to plummet in the future.
Are Index Funds Good Investments in a Bear Market?
The truth is that Index funds, like all other forms of investment, come with risk. There are advantages and disadvantages to utilizing an index fund. While investing in an index fund will likely get you a higher rate of return than blind investing, that doesn't mean it will reap a higher reward than a meticulously planned and crafted mutual fund that's continuously optimized. Still, for every argument against index funds, there's a counterpoint somewhere.
As for an index fund's performance during a bear market, they're far from risk-free. There's a good amount of risk with an index fund, especially at a market level. That doesn't necessarily mean that you shouldn't invest in mutual funds but instead work to incorporate them as a piece of a more extensive portfolio.
If you're considering an index fund or would like to discuss investing in a bear market, please call or email to schedule an appointment with me. We can create a financial plan that can fit into your budget and help you pave the road to your financial goals.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.